Investors are being pushed further up the risk scale into illiquid assets in search of higher returns, even though interest rates look likely to rise within the next year

March 5, 2014 10:36 am

Illiquid funds offer top returns but high risks

By Emma Dunkley and Adam Palin

Investors are being pushed further up the risk scale into illiquid assets in search of higher returns, even though interest rates look likely to rise within the next year.

New funds are coming to market investing in illiquid areas such as distressed debt, property and asset classes once dubbed “toxic”, such as mortgage-backed securities. Investors are being offered yields above 5 per cent and high total returns.

Neuberger Berman, an asset manager, has launched a global version of its Distressed Debt investment trust on the London Stock Exchange, investing in senior secured debt issued by companies in Europe and the US.

“Due to the low levels of returns on cash and fixed income, investors are taking more risk, looking for niche investments opportunities to get a return,” said Thomas Becket, chief investment officer of PSigma Investment Management.

Mr Becket, who has invested in the trust, said European distressed debt offers a “once in a generation” opportunity thrown up by the European Central Bank’s asset quality review, leading banks to sell off bad debt sitting on their balance sheets at large discounts.

Consulting firm PwC estimates European lenders will sell €80bn of loans this year, spurred by the ECB’s review.

But experts urge investors to take caution as the level of complexity and risk to capital can be greater than equities or bonds.

Mr Becket warned it is “foolhardy” to treat these types of illiquid assets as mainstream investments. If the European debt market becomes “skittish” and nervous investors pull out, the trust’s share price could fall, leaving it trading at a large discount to its net asset value.

Many of the more illiquid asset classes are held within investment trusts, as opposed to open-ended funds.

As trusts issue a fixed number of shares, the manager is not required to manage inflows and outflows, which tend to force purchases and sales at inconvenient times.

However, some fund groups are attempting to deliver exposure to higher-yielding alternatives through an open-ended fund structure.

North Row Capital has opened a fund for retail investors offering up to 5.5 per cent, although instead of investing in illiquid physical property, it holds derivatives, property equity and debt.

“It’s an onshore Ucits fund, so it has daily liquidity, unlike many other property funds,” said Darius McDermott, managing director at Chelsea Financial Services.

“It uses derivatives to mimic the returns of commercial property and has a higher prospective yield than other commercial property funds on the market,” he added. “But it does hold some commercial property debt, which is interest rate sensitive.”

However, futures on property indices can also lack liquidity, while other forms of property derivatives, such as structured notes and swaps, can leave investors exposed to counterparty risk.