Woodford Equity Income – How did it all go wrong for this ‘star’ manager?
There has been a lot of noise in the press this last week or so about the Neil Woodford debacle. This ‘star’ manager has had to suspend his flagship fund, meaning investors cannot get their money out. Many do-it-yourself investors were attracted to this fund on the back of the manager’s previous performance (has there ever been a clearer example of past performance not being a guide to future performance?) and I would wager that a large proportion of them didn’t even know that funds could be suspended in this way.
So why did it happen? First of all we need to understand a few basics about investment funds. An equity fund aims to make profits by investing in companies, buying and selling their shares. Some of these shares will be listed on a public market, such as the London Stock Exchange, and are liquid – there is a ready market for them and they can be bought and sold relatively easily on demand. But a fund may also be allowed to hold shares in small companies that are not publicly traded and for which there may be a limited, or even no, ready market. Selling them can take a long time. Of course, these unlisted shares have the potential to deliver highly attractive returns…or deeply unattractive losses. And if a fund holds too much unlisted stuff and some of it goes wrong, it can’t be quickly sold. The performance of the fund overall will be affected, leading to many investors seeking to withdraw their money.
Now we need to look at the fund structures. Funds are either closed-ended or open-ended. A closed-ended fund issues a fixed number of its own shares and these are traded on a stock exchange. If you want to invest in such a fund you need to find someone who already owns shares in it and who wishes to sell. If you own some shares but want to raise cash you need to find someone to buy the shares from you.
An open-ended fund (such as Woodford Equity Income) is divided into units which can be created and cancelled as necessary. If you want to buy some of this fund you hand over your cash and units are created for you. If you wish to sell, the fund manager cancels units and pays out the cash to you. In normal times he runs a cash float for this, but if too many investors wish to cash out at the same time, some underlying assets have to be sold. And here is the nub of the matter. If the fund holds both liquid and illiquid assets, and needs to raise some cash quickly, the only option is to sell the liquid ones. So, if redemption requests get too high and the manager has to sell a lot of the liquid assets (and probably as a forced seller, so getting poor value), the unlisted holdings become comparatively larger. This ultimately leads to a fund holding more unlisted assets than it is allowed to, and so, to avoid a rule breach, the fund may need to be suspended.
People are essentially herd animals. When we see something doing well we all jump on the band wagon. When it starts hurtling down hill too fast, we all scramble to get off. If a fund starts to perform badly the natural instinct is to pull out of the fund and the equivalent of a bank run can follow. And that is where the difference between closed- and open-ended funds becomes apparent. You can only get out of a closed-ended fund if you have a buyer, and if there are no buyers then a ‘bank run’ can’t get going. But an open-ended fund must cancel units and pay out. Once the withdrawal demands reach a level that means the required cash cannot be raised, slam! Down come the shutters.
So what can we do? Well, I’m sure you’ll forgive me, but the simple answer is to take proper advice. A leading fund platform that markets to the do-it-yourself investor has got itself into a bit of hot water over the Woodford fund. It had placed this fund on its ‘buy list’ and a lot of investors made their decisions on the back of that, without taking any advice. The platform is now facing claims from people who bought this fund because it was on the platform’s ‘buy list’, even though the buy decision was theirs alone.
I started this article referring to the ‘star’ status of some active fund managers. I recently watched a very interesting documentary about the Chelyabinsk Meteor that entered Earth’s atmosphere in February 2013, like a shooting star. Seconds later it exploded in the most spectacular fashion causing a massive shockwave, extensive damage to infrastructure and injuring many residents. Take proper advice and don’t let the next star injure your wallet.
The 2013 Chelyabinsk Meteor exploding 30km up in the atmosphere, filmed from a passing vehicle’s dashcam.
Philip Chandler FPFS, CFPTM, Chartered MCSI
Chair of Aspinalls Technical and Investment Committee