The lessons learned from Woodford’s woes
On Monday this week, trading in the LF Woodford UK Equity Income fund was suspended until further notice, following large withdrawals from investors.
The fund is managed by one of the best-known stock pickers in the UK in the shape of Neil Woodford. The veteran fund manager set up his own business in 2014, having built a huge following of loyal investors during his time at Invesco: returning 23 times his investors’ money over 25 years.
However, having seen outflows of roughly £9m every working day in May from the LF Woodford Equity Income fund, the decision to suspend it was designed to stop investors transferring or redeeming any further assets in the next 28 days. To put this into context, in June 2017, the fund held some £10.2bn of assets but this had fallen to £3.7bn at the time trading was suspended.
While this has not pleased many people, the move was made to give the manager time to both sell more of his holdings (to meet the increased demand to withdraw assets) and to get better prices for those holdings than he would do if he was having to fire sale the stocks – which is in the interests of existing investors. After 28 days a call will be made on whether the fund can start trading again.
The suspension of trading of such a high-profile manager has made major headlines – but what are some of the lessons investors can learn from the news?
Why has this happened?
We estimate some £200m of assets had been withdrawn in the four weeks prior to the suspension, but the big blow came when Kent County Council decided to withdraw £263m of assets.
The withdrawals, which had been significant but steady over the past 18 months or so, came after consistent underperformance from the fund: if an investor had put money into the fund three years ago, they would have lost 18.96%* of their investment.
Why has it underperformed?
The underperformance has been due to a number of factors. Firstly, Neil’s style of investing has been out of favour. He holds many unloved and undervalued companies, which are domestically focused. But as Brexit drags on and on, they have not been given the opportunity to recover. There have also been a number of stock-specific issues, where individual companies he has invested in have suffered sharp share price falls.
Added to this is the fact that Neil has been facing net redemptions for many months – it is very difficult to outperform when you are having to sell holdings instead of stay invested – and the knock-on effect has been a vicious cycle of underperformance and more redemptions.
Why is liquidity important?
The news reports in recent days have been talking about ‘liquidity’. This is an important aspect of investing – and refers to how easy or difficult it is to buy or sell certain assets. For example, some large companies have many millions of shares that are bought and sold every day. These are called ‘liquid’. Smaller companies may have far fewer shares that are traded less regularly. That makes them ‘illiquid’. If a fund needs to sell too quickly, it can result in a fire-sale which means assets will have to be sold at a reduced price. A good example would be to consider the scenario that you would have to sell your home in one month – while selling your home is possible, you might have to drop the price considerably to guarantee it is sold that quickly.
This is an issue we have seen happen a couple of times in the past decade or so, with property funds, which invest in physical assets. The most recent occasion was in the wake of the EU referendum result where property values fell, and a number of property funds shut their doors to ensure they did not have to sell at much lower prices in a bid to protect remaining investors.
The importance of portfolio diversification
Diversification is one of the principle rules of investing – do not put all your eggs in one basket! Funds (and asset classes) often have completely different risk profiles and diversifying across both increases the chances of producing smoother returns. While it will be worrying and frustrating for investors who cannot access their money in LF Woodford Equity Income fund, if they have other investments and need to get hold of some capital in the next few months, they will still be able to do so. Likewise, while LF Woodford Equity Income has not performed very well, other funds – whether they are equity income fund or invest in other assets – will have done better.
And awareness of stock-specific risk…
Further to the diversification argument, investors must also be aware of stock-specific risk. Equity funds invest in a number of underlying companies of varying sizes – and the allocation to each company will reflect the confidence a fund manager has in that holding. Higher conviction funds (with fewer underlying stocks/companies) are more likely to feel the effect of the poor performance of one or two companies, than those which are more widely diversified.
While this will be a worrying time for investors, it is important not to panic and not to stop investing. This is a very rare occurrence.
Darius McDermott is managing director at Chelsea Financial Services
*Source: FE Analytics, total returns in sterling, three years from 3 June 2016
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.