In fund managers we trust: Lessons from the Woodford fallout

10 mins. to read
In fund managers we trust: Lessons from the Woodford fallout

While the fight to salvage Neil Woodford’s career rages on, James Faulkner examines the lessons investors can learn from Woodford’s mistakes.

Neil Woodford, once hailed as Britain’s answer to Warren Buffett, has seen his media image go from hero to zero in the matter of a few years. Following the suspension of his flagship Woodford Equity Income Fund, there has been a torrent of media vitriol aimed at Woodford over the past week.

I don’t wish to add to the finger-pointing here; but what I do want to do is tease out the lessons private investors can learn from Woodford’s mistakes and ultimate downfall, so that we don’t repeat them with our own investments.

Beware the cult of the ‘star manager’

Much of Woodford’s reputation as a great investor was based on two key decisions: his refusal to take part in the boom and his backing of big tobacco companies when they were out of favour in the ‘90s and the early 2000s; and the fact that he stayed clear of banks before the Financial Crisis. Clearly, these were both wise decisions at the time, and helped Woodford to deliver 23 times investors’ money over a 25-year period.

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However, at some point along the way, the attention shifted from Woodford’s investment decisions to the man himself. That’s where the danger started – here was a man who was worth investing in, simply because he’s Neil Woodford. That sort of personality cult can have a very toxic effect on both the person in question and the people that should be holding them to account. People started to believe Woodford was a genius – most dangerously perhaps, Woodford himself.

The lesson here for investors is that it is easy to get carried away when things work in our favour and our investments perform well. But it is at this point that we have to be on our guard for that most dangerous of human emotions: hubris. The fact that Woodford rarely gave an interview or attended industry events added to the cult of untouchability but also shielded him from a significant amount of scrutiny. Of course, there were a few critical voices in the media – but they were drowned out by the army of sycophants who bought into the personality cult of “Britain’s Buffett”.

One interview with the FT in 2017 says it all. In it, Woodford claimed that, “You have to have a sufficiently strong arrogant gene to back your judgment, back your conviction.”

Understand the difference between open-ended and closed-ended funds

Anyone who invests in funds has to understand the differences between the two main types of fund: open-ended and closed-ended. They are both very different vehicles with very different characteristics.

An open-ended fund is essentially one where money can flow in and out of the fund with ease. Investors purchasing units in an open-ended fund deposit their money with the fund manager who then creates new units based on the prevailing unit price. That money is then added to the pool of capital available to make investments and meet redemptions from unit holders. This model is highly scalable and hence is the most favoured by fund management outfits (there is much more money under management via open-ended funds than there is via closed-ended funds).

Closed-ended funds, such as investment trusts, take a different approach. They raise money through selling shares via an IPO. There is a fixed amount of capital and the fund’s shares trade on the stock market like any other company. Investors can buy and sell shares on the open market and shares can trade at a discount or premium to the underlying net asset value (NAV).

The fact that closed-ended funds can be traded on the stock market means that their managers don’t have to worry about meeting redemptions from investors. This is a key characteristic which makes them rather useful when it comes to investing in assets that are illiquid, such as infrastructure or unquoted companies.

In principle, the Woodford Patient Capital Trust (LON:WPCT) was a good idea. Young companies with novel technology need long-term, “patient” capital in order to grow and thrive, and that was what WPCT was set up to provide. Shares in these kinds of companies also tend to be illiquid, meaning they can be difficult to trade, so an investment trust was indeed the ideal vehicle to invest in such assets.

However, in what was clearly a huge miscalculation, Mr Woodford decided to also invest money from his more conservative Woodford Equity Income fund into these higher risk, more illiquid plays. Whilst a sustained period of underperformance might not prove much of a problem for a closed-ended fund, it can wreak havoc for an open-ended fund, as the manager has to meet redemptions from selling into an illiquid market. This can quickly lead to a downward spiral of the kind Woodford is seeking to protect against by the recent suspension of the Equity Income fund.

The lesson to be learned here is to make sure you choose the right vehicle for your investments. There have been some similar examples where open-ended funds investing in illiquid assets have come unstuck recently – with the suspension of some open-ended commercial property funds after the Brexit vote being an obvious one.

Be wary when a manager steps away from his/her core mandate

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Woodford’s bread-and-butter was investing in large-capitalisation companies with defensive business models. But, since establishing his own business, he gradually departed from this in favour of pursuing increasingly speculative investments.

The stock market is littered with examples of companies that tried to ‘diversify’ and ended up blowing up because they were operating in an area outside their own competencies. Being an investor, Woodford is no doubt aware of this. Yet he chose to do exactly that when investing his clients’ money.

We all know from our own investing experiences that we often make our biggest mistakes when we are tempted away from our core investing styles into investments that appear more exciting or attractive at the time. Woodford did not have a background in investing in unquoted companies, yet he chose to do so within a fund that was billed as a conservative investment for retail investors.

Essentially, anyone looking under the bonnet would have found out that Woodford Equity Income wasn’t doing what it said on the tin. Woodford himself admitted as much in a recent portfolio update, when he told investorsthat, “The fund’s exposure to unquoted securities, including those listed on less well-known exchanges where there is little or no trading activity, will decline over the remainder of this year to below 10%.”

Treat ‘best buy’ lists with scepticism

Woodford Equity Income was a favourite of fund ‘best buy’ lists, chief among which are those of the various investment platforms. These have long been an area of controversy for the investment industry, but one suspects the debate surrounding them will intensify following the Woodford debacle.

Before the Retail Distribution Review – legislation that introduced new rules regarding the sale of investment products to the public – the debate was primarily focused on the commission earned by the platforms that recommended funds; now it’s all about whether fund management companies are negotiating discounts in order to secure their place on a list. In the latter case as well as the former, the impartiality of such ‘best buy’ lists is understandably called into question.

The bottom line here is: don’t take the platform’s word for it! Do your own independent research on a fund beforehand. You can find a lot of useful information on websites like Trustnet or the AIC, both of which offer performance statistics and analysis that can be useful when comparing different funds.

High-yield, high risk?

Woodford’s mistakes with small, illiquid, early-stage and unquoted companies is just one half of the story. The other problem is that many of the larger companies he has invested in have also proven to be poor investments.

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Investing for income entails looking for opportunities among stocks with higher than average dividend yields. The problem with this approach is that such stocks often have a high yield for a very good reason. For example, they could operate in a mature industry with little growth potential; they could face disruption from competitors with new technology or products; and/or they could carry large amounts of debt, leaving their financial position exposed should trading take a turn for the worse.

Several holdings within the Woodford Equity Income fund have come unstuck for the above reasons, notably Provident Financial and Kier Group. Given that many equity income funds like Woodford’s are presented to the investing public as relatively dependable products that invest in strong companies with defensive characteristics, many investors may have been surprised to see some of the portfolio investments blow up like this.

The lesson? There is no free lunch. Income funds do come with risk attached. As quantitative easing has driven up asset prices and eroded the yields on offer across the board, it is quite possible that Woodford was driven into lower quality investments as a means to generate an attractive yield to his investors. Investors need to think about the sustainability of their income before they get excited about the size of the yield on offer.

Don’t spread yourself too thinly

When he was at Invesco, Woodford had an army of analysts and compliance people helping to guide his decisions and make sure he operated within the rules. When he established Woodford Investment Management, he had to create all that from scratch.

Woodford insists that his focus was the day-to-day management of the funds, while the running of the business itself was left to the CEO. But it would seem unlikely for Woodford not to have been drawn in to at least some of the details of a business which he founded, which bore his name and in which he held a majority stake. Throw in the fact that Woodford was now running three large funds and also delving into areas where he had little prior experience, and it seems perfectly plausible that he took his eye off the ball and spread his time too thinly.

The bottom line? If you don’t have time to properly research and monitor your investments, consider passive investing.

On the contrary, the markets can – and do – get it right…

High-conviction, contrarian investing of the kind that Woodford eschews is all very well and good when you get it right. However, while I don’t subscribe to the Efficient Market Hypothesis (EMH), the markets occasionally do get things right and yesterday’s bargain can often become today’s falling knife.

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The other problem with contrarian investing is that it requires a certain amount of self-belief – “a strong arrogant gene”, in the words of Woodford – in order to take an opposing view to the vast majority of market participants. If this self-belief turns into something more akin to hubris, then you have a problem.

The US fund manager Ken Fisher likes to call the market “the Great Humiliator” – it always gets you in the end. We have all had our fair share of dogs – hell, Berkshire Hathaway itself is named after one of the worst investments Warren Buffett, the great man himself, ever made. But what separates the really great investors from the not so great ones is how we deal with and learn from those mistakes. Warren Buffett could have easily changed the name of Berkshire Hathaway when it became the holding company for his investments – but he didn’t. Instead, it would serve as a reminder of his own fallibility.

The fight is on to salvage Mr Woodford’s career, and although he has clearly made some very big errors of judgement lately, he still has a very impressive long-term track record behind him, notwithstanding the recent falls. The real test for Woodford – and for all of us as investors – is whether he can understand and come to terms with his mistakes, and then learn and move on from them.

Comments (3)

  • marshal says:

    .’Woodford did not have a background in investing in unquoted companies’ you say. Not so, he previously launched the Invesco VCT, He failed in the same way as WPCT. So I stagged WPCT and stayed out. He handed IPVCT to DrJourdan , and saved the day, I now have WPCT at 60p, and expect the directors to find a proper manager.

  • Lawman says:

    Another “lesson” is that the board of directors of an IT should include independent Non-Executive directors. WPCT has only one.

  • Ben says:

    And what about HL in this story who helped to attract and lure many innocent victims into this going astray hero. Another lesson to be learned, doubt trust your investment platform when the same as Woddford did thigs outsode your business scope.

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