In long-horizon investing, ‘lock-up’ is a term that attracts much attention and debate. In theory, it would give asset managers a stable capital base for effectively pursuing their long-term strategy without worrying about being forced to sell by redemptions.
This is particularly important given the fact that some of the best returns can be made in times of market distress, which is when asset owners often seek to redeem investments. However, for various reasons, many owners are reluctant to commit to locking up capital (particularly in long-only public markets).
In this article, I review open-end and closed-end structures in the context of some findings from academic research.
Intuitively, in an open-end structure, provision of liquidity to investors (redemption) can have a negative impact on returns; for example, in fire sales that price assets below fair value to meet redemption calls. The empirical evidence clearly lends support to this argument. Roger Edelen, from the Wharton School of Business, in his paper “Investor flows and the assessed performance of open-end mutual funds”, built a sample of 166 open-end mutual funds and concluded that liquidity-driven trading in response to flows has reduced returns of US open-ended mutual funds by 1.5 per cent to 2.0 per cent per year from 1985 to1990.
In a separate study, the US Securities and Exchange Commission’s Woodrow Johnson constructed a proprietary database that includes a panel of all shareholder transactions (just under a million, on 50,000 stocks) within 10 funds in one mutual fund family between 1994 and 2000 in the US. His findings are similar to Edelen’s: the cost of open-endedness is about 1.1 per cent a year.
Johnson further suggested that under the current structure (i.e., no pricing differentiation with regards to trading frequency), long-term shareholders who have relatively small liquidity demand are, in effect, subsiding short-term shareholders who access liquidity. In my mind, this raises the question of whether open-end structures in their current form are fit-for-purpose for long-horizon investors.
It’s not that simple
Now we might be tempted to conclude that – everything else being equal – closed-end funds should, in theory, outperform because they can avoid being forced sellers. Well, unfortunately, not everything is equal here. The lack of monitoring and alignment (in the absence of the threat of redemption) can lead to serious agency costs and underperformance for closed-end funds. Barclay et al found that the greater the managerial stock ownership in closed-end funds, the larger the discounts to net asset value. The average discount for funds with blockholders (shareholders who own 5 per cent or more of the fund’s common stock) is 14 per cent, whereas the average discount for funds without blockholders is only 4 per cent.
Researchers attributed the agency costs to blockholders extracting private benefits – such as receiving compensation as an employee – and blockholders owning companies receiving fees for service to the fund, as examples.
Both structures can succeed
As with many situations in investment, there doesn’t seem to be a universally agreed upon winner of this debate. Both structures could potentially add value and both structures could destroy it if ill-executed. If asset owners can manage to get themselves over the line about the concept of lock-up, and a proper monitoring mechanism is in place, closed-end funds do seem to give managers the highest degree of freedom to turn their skill into better returns.
On the other hand, an alternative to requiring lock-up could be looking for ways of avoiding the cross-subsidy between flighty investors and committed long-term investors, along with providing a better and deeper articulation to asset owners of how long-term strategies should be assessed and measured. This could include a clear articulation of the underlying long-term investment thesis and specification of when the strategy is likely to underperform.
With that, when short-term underperformance inevitably comes around, asset owners are more likely to stay on course as long as the underlying investment thesis remains intact.
Liang Yin is senior investment consultant in the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.