Neil Woodford, one of the UK’s best-known fund managers has recently had to suspend trading in the Woodford Equity Income Fund for an initial 28 days, which prevents investors from withdrawing assets from the fund, to allow him time to remodel the portfolio.
Some investors are claiming not to know how the fund was invested, which is surprising given his well-known contrarian approach and his transparent strategy for allocating capital to smaller firms, alongside large cap shares. Woodford, investors, best-buy lists, potential conflicts of interest, the press, and regulators all share some of the blame.
The key lesson to be learned is that active fund management adds additional layers of risk including stock concentration, tracking error, liquidity and manager strategy risk to portfolios. In a world where markets work pretty well and manager fees are high relative to likely skill, one should question whether these risks are worth taking. Woodford provides a helpful reminder of the challenges and dangers of doing so.
There is much academic debate around the degree to which luck plays a role in investment returns, which is largely beyond the scope of this note. However, what we do know is that being a high conviction manager, who owns a portfolio significantly different to the broad market, means that there will inevitably be periods of time when the investment thesis will be right (or lucky) and other times when it will be wrong (or unlucky).
This Sunday’s papers made for grim, and at times unfair, criticism of one of the UK’s most renowned investment managers. Is Woodford a villain or victim in this tragedy? In a sense, a bit of both.
We have some sympathy for Neil Woodford, who is a long-term, high conviction investor, and who has been entirely transparent with the holdings in the fund, which are published monthly on the firm’s website. Only the naïve, or the ill-advised, should have been surprised that his fund could deliver returns materially below (as well as above) the market, given his track record and his well-publicised liking for smaller, often unquoted, company shares.
Investors and their advisers should not escape the hook for this either. To only take the good times and run for the door in the bad times strikes us that these investors should not be allowed near an actively managed fund of this nature. Many appear not to know how the fund is structured, have little stomach for tracking error and lack patience. Advisers, who put their clients into the fund should be asking themselves if they truly understood their clients, and if their ongoing due diligence and governance was all it should have been.
Online brokerages, such as Hargreaves Lansdown (HL), also share some of the responsibility. Best-buy lists do not constitute financial advice, but perhaps they should; without any doubt they can materially influence investors, some of whom may not have much experience of investing. Hargreaves were a major distributor of the funds, had negotiated a large reduction in the fees from Woodford, and until last week, the Woodford Equity Income Fund remained on the Wealth 50 best-buy list.
The FCA appears to have stepped in quite late. No doubt they will investigate what has been going on but should reflect on how they monitor funds with illiquid stocks, the use of best-buy lists, possible conflicts of interests between fund management firms and platforms, and general suitability when it comes to recommending highly active funds. Finally, the media and press, circling like vultures, have added to the stampede and the steep fall in prices. No-one has covered themselves in glory.
Lessons to be learned
This sorry state of affairs reinforces some very important lessons for investors, which have come at great cost to those invested in the Woodford Equity Income Fund.
- Risk and return go hand-in-hand: if you own an actively managed fund that is quite different to the market, it returns will be too, both on the up and the downside.
- Skill is very rare, and luck plays a major role in most active managers’ periods of outperformance. Markets work pretty well, and market-beating performance is likely to come only from taking on higher risks e.g. owning smaller companies. After costs, the empirical evidence suggests that very few active managers deliver skill-based returns sufficient to cover their costs over the sort of horizons that investors require.
- In the same way that noise and luck play a big role in fund manager outcomes, this is also the case when picking active funds. Best-buy lists and advisers active fund picks are highly susceptible to this noise.
- Concentrated stock positions, combined with low levels of liquidity, is a dangerously potent cocktail that represents a material risk to investors’ wealth.
- High levels of diversification in liquid, quoted companies, ensuring that no small set of companies dominates outcomes, is essential.That is why the total number of shares held in our clients’ portfolios is in the thousands.
- Gambling on which fund is going to beat the market is an exceptionally low probability strategy. Capturing the market return is a valid and worthy objective.