Neil Woodford: lessons

The suspension of the LF Woodford Equity Income fund marks one of the most significant moments in the recent history of the fund management industry.

At a time when the merits of fundamental long-only active fund management is under constant challenge it will cause widespread re-appraisal of the extent to which financial advisers should back individual talent with their clients’ money.

We should avoid a hysterical response. Whilst this fund is suspended it is now, at a little over ￡3 billion, a vehicle that can in time be properly re-balanced without creating a market shock. Neil and his team will have in their hands the needed tools to use trading techniques that prevent the investor becoming a forced seller. The actual long-term economic damage done to these unitholders may not be as great as it immediately appears. The firm will do this with diligence and care, these are not rogues they are people who care about their clients. They were just wrong.

Perhaps though there is merit in learning some lessons.

Firstly, we should start by acknowledging Neil’s prodigious talent. He has for a long time understood a rarely understood feature of active fund management; opportunity is not linear.

The vast majority of the profession establishes funds that take a consistent level of active exposure on an on-going basis regardless of market conditions. In reality though alpha is so often generated at moments when significant arbitrage opportunities open up as a result of major valuation anomalies or irrational pessimism and optimism.

For two decades Neil has understood that he has to take a fundamental long-term view on what he believes in and tolerate periods of significant underperformance to leverage these opportunities. There have been moments in his career where he was on the verge of losing his job – not least when he avoided technology stocks as the bubble built – but he stuck to his guns and was rewarded.

He is an individual who has avoided many of the heuristic errors that have plagued his peers. So how on earth did we get to this point and how do we avoid it reoccurring?

The first lesson must be this.

When you look back at the times when things have gone wrong in this industry there is a persistent feature: The creation of investment vehicles where the vehicle offers a superior level of liquidity to the underlying investments. I have lost count of the number of times I have used this phrase when crises hit the industry.

The examples range from the high-profile problems with Keydata and Arch Cru through to lower level dramas like the problems experienced by listed fund of hedge funds when they breached their covenants during the global financial crisis or the direct property funds that were forced to suspend trading.

Open-ended funds are designed for liquid investments. At times investors pay a price for this because it prevents fund managers backing long-term systemic illiquid opportunities that may offer strong and predictable cashflows. Yet this is the reality of the structure. If you choose it you must be comfortable forgoing those opportunities in favour of at times less attractive liquid ones.

The level of illiquidity in this fund was only tolerated by the fund manager because of an assumption that the fund would enjoy a high level of asset stability and growth. But again, an open-ended fund cannot be invested on the basis that it will always grow, that the investor will always have a steady flow of new money.

The second lesson may be this.

It is not the worst idea in the world to ask a fund manager how they invest when they are in redemption. It is an often overlooked feature of fund management that it is far far easier to invest during a period of inflows. Often though managers who have been through challenging periods are perceived as individuals whose shine has come off and avoided. These can be powerful learning experiences and we should place great weight behind individuals who have proved they can prosper during both out and inflow periods.

Finally, I offer this thought. As an investor community we are hugely comfortable with the notion of diversification. We would never seek to build a business or invest a client in one strategy that could determine their future. I am nervous about fund management companies that do this.

When a fund management boutique is established it is of course usually done using one strategy built around a known individual. But I am hugely comforted when that individual has the humility to recognise that their talents alone will not create the diversification needed to safeguard their own wealth, who simply believe they are ‘good enough’ to carry the whole business.

This humility in business strategy is a good litmus test for the humility applied to the investment process.

So what is next? I have no doubt that Woodford Investment Management will work hard to right this wrong but it must be acknowledged that the loss of the institutional mandate from St. James's Place is highly significant. It would be na?ve to believe that simply recovering the performance of this fund will recover the position this firm once enjoyed within the industry.

It will take more than that.

I would hope that rather than simply apologise there is an acknowledgement from Neil of the fundamental lessons learned from this debacle about the role of liquidity in managing an open-ended fund.

My best guess is that he is likely to ultimately close Woodford Investment Management as a retail business and move into the private management of assets. It would not surprise me in the least if over the coming decade he was able to deliver those investors superior returns. I do not doubt his integrity, but it is difficult to see this firm returning as a major force in retail fund management.