Challenging Howard

Of course, mortgage funds are by definition not liquid investments, since they are dispersing funds for, in the case of Challenger Howard Fund, terms of (usually) 1 to 3 years with no certainty of repayment. You'll struggle though to find a research house, licensee or fund manager who in the last five years ever said that they weren't suitable for inclusion as part of a client's fixed income/liquid allocation within portfolios.

What's sad about this case is that, at least in my experience, the fund was promoted at adviser level as a suitable cash and liquidity alternative and right up until a few days ago the manager was in total denial that a liquidity freeze might be necessary.

Now we moved some time ago to fully redeem from mortgage funds because we simply didn't believe manager assurances, but what of those advisers who, in good faith, did? What are they to do when yield and mortgage funds, which form the backbone of allocated pension liquidity in many client accounts (as per the standard model of financial planning asset allocation pushed by fund managers and professional associations/educators), no longer permit withdrawals?

They will now be pilloried by press, regulators and clients for giving inappropriate advice, when large, credible organisations that often have a financial interest in advisers' businesses provided unequivocal reassurances that their worries were unfounded.

More generally, the financial planning profession and the regulators need to issue as soon as possible a strong statement of principles around the issue of liquidity constraints on funds because many advisers feel the area is rife with abuse.

While in the context of a short-term run of redemptions and a chaotic market restricting redemptions makes sense, from what I am seeing fund managers don't seem to appreciate that from an adviser's perspective a fund shifting from liquid to illiquid radically changes the game.

A fund manager who makes the decision to freeze in fact makes three decisions, not one:

- It restricts an investor's access to his or her funds; it implicitly makes a call that near-term future asset prices will exceed current prices (i.e. it asserts that current 'fire-sale' prices for the fund's assets will be exceeded within a short space of time by prices above the current level.

- It asserts that such a recovery in prices will occur within a short space of time because it has frozen in the expectation of numerous redemption requests.

- It, therefore, has a reasonable basis for believing many if not all of the unit-holders desire return of funds and hence knows assets would in the normal course of business need to be sold to fund these redemptions.

Given that, for a manager to not sell assets in expectation of a longer-term recovery in values makes little sense, since the manager is failing to take into account the time utility of funds in the hands of unit-holders). It implicitly makes a call that the manager believes that allocation to the fund's asset class provides a superior risk-adjusted opportunity than that of other available alternatives the unit-holder or the unit-holder's adviser may wish to consider.

Where this is going is that when a manager freezes redemptions it needs to recognize that a failure in risk management and asset selection has occurred. It's not inappropriate for a manager to go illiquid, but it is inappropriate for a manager to stay illiquid, when the unit-holders on the register invested with a reasonable expectation of liquidity. Of course, managers can point to PDSs which discuss the potential for illiquidity, but that ignores the reality of industry practice and what managers actually tell advisers and clients at the time of investment.

Accordingly, a fund manager who makes the decision to go illiquid should be required to have two overriding objectives:

1) Preserve unit valuation and

2) Get positioned to offer a broad redemption of unit-holder interests as soon as possible.

It's completely immoral for a manager who has locked up clients' funds to keep on investing and transacting with unit-holders' cash and liquid assets while in a redemption freeze. Illiquid assets in a frozen fund should be treated as being within a conservatorship pending realization with fees modified accordingly.

Plenty of hybrid funds with 30-50 per cent cash and liquids have frozen redemptions over the last few months and yet to the best of my knowledge none of them have offered or insisted upon a pro-rata return of their cash and liquid assets, arguably because redemption freezes are as much about protecting manager's fee flows and businesses as they are about protecting unit-holders' equity.