Lessons from Woodford
Unless you have been lucky enough to be living in a cave in the middle of the Amazon rainforest for the past couple of months, it has been impossible to ignore the furore surrounding the suspension of the Woodford Equity Income fund and the fall from grace of the UK’s highest-profile fund manager of the past 20 years.
Much has been written in the press, with my own comments cropping up far and wide across the world, showing the global reach of this story. However, now that the dust has settled, a little at least, it’s time for some reflection to understand the issues at play and also to try and understand how investors can learn from the events that have unfolded.
As we all know, the fundamental issue at play is a mismatch between the liquidity available in the fund and the terms of access offered on the fund. Or, in simple terms, offering daily dealing to investors when the underlying assets can’t be sold to meet the redemption requests. The tipping point came when the Kent County Council pension scheme asked to redeem its £263m investment in one go. At that point, the ACD of the fund, Link Fund Solutions, had no option but to suspend the fund as there was insufficient cash to meet the request and the underlying assets couldn’t be sold without taking a material hit on the share prices, which would have adversely impacted remaining shareholders.
We all know the background, but could investors have known this risk existed? One of the differentiating factors with Woodford has actually been his high level of transparency for investors. From the start, the full list of holdings has been published every month, allowing everyone to see exactly what is in the portfolio. This transparency should be applauded, and others should follow, but what it did mean is that the liquidity issues in the fund were actually there for all to see.
It was analysis of the underlying positions and how the fund was becoming less liquid as redemptions increased that prompted AJ Bell to remove the fund from our ‘Favourite funds’ list as soon as the responsibility for research was brought in house in September last year. In essence, all of the information that was used to make this decision was freely available in the public domain. However, it seems that liquidity analysis was not an issue that was high on the radar for investors in the Woodford Equity Income fund and probably, for that matter, in any other fund as well. I think we can assume that things will be very different going forwards and we, like many others no doubt, have reviewed our investment process to ensure we have an appropriate focus on liquidity to ensure we can identify issues before they emerge.
The bigger issue when thinking about liquidity is whether an open-ended fund is the appropriate structure for illiquid assets at all. Interestingly, this issue has actually been reviewed by the FCA in recent months, but they were only looking at the obviously illiquid assets, such as physical property and infrastructure, with initial proposals suggesting greater disclosure rather than any conclusion that the open-ended approach is inappropriate.
With the Woodford situation being an incredibly rare event (I can think of no other similar occurrence in my 20 year career), it’s understandable that less attention has been given to liquidity risk in recent years. However, with a shift in the way the market operates since the financial crisis, particularly in the fixed-interest market, we have been aware of increasing liquidity risk and certainly see increasing risk in equity and fixed-interest markets rather than just the obvious assets of property and infrastructure. This is borne out in the meetings and discussions we have with fund managers on a regular basis. As a result, we actually fed back to the FCA consultation on liquidity at the beginning of this year that we felt the scope of their work should be widened, particularly to include high-yield bonds and small-cap equities, both of which can prove to be very illiquid when market sentiment shifts. Sadly, we have been proved right and we will wait to see whether the FCA broadens the scope of its thinking.
With markets being relatively kind for a decade, there has been little reason for asset managers to change their approach to fund structures. Open-ended funds have been the default choice for years, but recent events could certainly prove an opportunity for the investment trust industry to take the lead. The closed-ended structure is well suited to illiquid assets and, while issues around premiums and discounts don’t make them a perfect structure, they certainly mitigate the suspension risk. Given this potential closed-ended advantage, it’s imperative for investors to use investment platforms and MPS solutions that can be ‘whole of market’, because being limited to open-ended funds only greatly limits the number of tools available to mitigate liquidity risk.
The alternative is that asset managers and investors accept that there has to be a trade-off when investing in illiquid assets. That trade-off surely has to be the ability to access your investment. Daily trading has been a given in the fund management industry for years, with little thought as to whether this is appropriate for the underlying assets. Funds offering weekly, monthly or even quarterly dealing are nowhere to be seen in the retail market, but surely when dealing with illiquid assets, offering access on a less frequent basis to match the liquidity of the underlying assets is a sensible way forward. In fact, in recent weeks the Investment Association has presented proposals for a change in approach. The trouble is, there is no advantage for any asset manager to follow this approach as, unless funds do it simultaneously, those offering less frequent access will surely be shunned by investors – even if they are more appropriate. As a result, it seems likely that only regulatory change will make this happen, but it will have to come with a high degree of education to help investors understand why less frequent access is in their long-term interests.
The active fund management industry has taken a lot of criticism in recent weeks, but I think it’s important to be proportionate in the wake of the Woodford situation. In my view, there isn’t a systemic liquidity problem in open-ended funds, but clearly everybody should be reviewing their processes to ensure that liquidity is understood and well-articulated. I do expect the FCA to look closely at the appropriateness of the open-ended fund structure for more than just property and infrastructure, and this may have repercussions for investors who need to understand that accessing the illiquidity premium has to come with a consequence, which is likely to be access.
No doubt there will be more to come out of the Woodford situation but, as ever, the importance of doing proper research, monitoring investments to see if they change and only ever investing in things that are understood should always be the cornerstone of any investment process. Events of the last few weeks have reminded us all that investors should never simply buy the name above the door without first checking what’s underneath the bonnet.