Woodford Equity Income: What Happened?

Woodford Equity Income is one of three funds managed by Woodford Funds. On June 3rd the fund announced that it was stopping its investors from pulling money out of the fund.

The event which seemed to trigger the decision to stop withdrawals was the decision by Kent County Council to withdraw from the fund. The council had over a quarter of a billion pounds invested in the fund.

Woodford offers three funds and only one has been gated, and this is the Equity Income fund which contained lots of unlisted companies.

The Patient Capital fund will never run into these liquidity problems despite containing lots of unlisted companies. This is because it is structured as an investment trust which means it doesn't have to sell its assets if investors sell their holdings because the fund is fixed in size. If someone sells their stake in an investment trust they have to find a buyer whereas open ended funds can expand and shrink as demand dictates.

What is Gating?

Let's say we create a fund to buy property. We get some investors on board, we buy a property that starts generating some rental income and capital gains. Other people buy into our fund and we use their capital to buy more property. These are the good times, money keeps rolling in and we build our fund's property portfolio.

Then something awful happens: a property price crash. Inevitably, some of our investors pull their money out of our fund. For the first few that leave we may have enough capital from the rental income to pay them off. But as the departures become a stampede we run out of cash and have to sell a property.

Selling a property in a crashing market takes a long time and we can't sell the properties fast enough. We simply have to stop people pulling out their money until we can sell some properties. Property is very illiquid which means it can take a long time to sell. When we stop people taking out their money it's called gating.

Lesson 1: Liquidity Risk Is Real

Financial engineering has made it possible to wrap illiquid assets in liquid funds. That means that under normal market conditions investors can buy and sell the fund very quickly, as if it were a normal share or fund. However, when there is a severe selloff and there are no buyers of the assets in the fund the liquidity disappears. The liquidity of a fund is the liquidity of its least liquid assets.

Lesson 2: Best Buy Lists Are Unhelpful

Best buy lists help people just starting out in investment navigate their way through the bewildering world of funds. For example, there are over four thousand Exchange Traded Funds which are available. Best buy lists steer investors into a much smaller list of suggested funds. However, the events with Woodford have called into question whether these lists are truly in the best interests of investors.

Although Hargreaves Lansdown were are pains to explain that they "never take payment or commission for funds to appear on the Wealth 50" they benefit from having more money invested on their platform. Also they often try and negotiate special discounts in return for selling the fund on their platform. Terry Smith, the extremely successful active fund manager, was nonplussed when he was repeatedly excluded from the Wealth 50 list.

In the case of Woodford's Equity Income fund the quid-pro-quo was that Hargreaves Lansdown received an exclusive reduced price share class reducing the cost of the fund for its customers from 0.6% to 0.5%. Woodford benefitted from positive marketing from Hargreaves Lansdown which resulted in its customers putting their money into Woodford's fund. The image below shows the extent to which support from Hargreaves Lansdown helped drive profits for Woodford.

Lesson 3: The Alpha Cult Is Dying

Alpha is the financial jargon for the percentage by which a fund outperforms the broad market. There is a belief in the world of investment which is so widespread that we don't even question many of its assumptions because so many people assume they are true. So to spell out the belief, here it is:

These beliefs are taken as given by an entire industry. What happened at Woodford is simply a symptom of the Alpha Cult. People assumed, straight from the Alpha Cult's two central beliefs that (1) Woodford was able to pick stocks that would consistently outperform the market and that (2) his amazing two-decade track record was evidence that he could continue to outperform.

The usual sequence of events that seems to repeat endlessly is as follows:

1. An active fund outperforms for some period of time
2. Money journalists sing its praises, laud the manager
3. Platform “research” markets the fund
4. The fund grows rapidly
5. The fund starts underperforming

An entire multi-billion-pound industry is founded on the beliefs of the Alpha cult. Active fund managers handle huge amounts of money and their trading fees generate large revenue for brokers and investment banks. Those brokers and investment banks publish "research" which analyses single stocks to help active managers choose the winners, but one purpose of this "research" is to generate more trading revenue. Best buy lists from the likes of Hargreaves Lansdown serve a similar purpose which is marketing. Some financial advisers offer a range of expensive active funds because it may be hard to justify charging a fee to recommend cheap passive funds which investors could buy themselves. And "discounts" for active funds are anti-competitive because they lock investors onto platforms with the most discounts.

Lesson 4: The Bogle Cult Is Growing

As usual the US is ahead of the game when it comes to investing. The stampede out of active managed funds into cheaper passive funds has been underway there for some time and does not seem to be slowing down. In Europe, where many investors still cling to the Alpha Cult beliefs, passive funds are taking longer to supplant active funds. However data on flows into and out of funds show that in Europe and the UK the message is getting through. Just as Christianity supplanted pagan beliefs in Europe in the early Middle Ages the new belief system that is replacing the Alpha Cult could be called the Bogle Dogma, named after its chief proponent (and founder of Vanguard) Jack Bogle.

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