It isn’t often that news in our industry makes it on to prime television or front page of the newspapers, so when it does, it must be something serious? This week has seen one of the most well-known fund managers, Neil Woodford, temporarily suspend any redemptions from (and for those who are the sternest of contrarian investors, any investments into) his flagship fund, the Woodford Equity Income fund.
The fund, which at its peak had over £10 billion invested, saw assets dwindle, through a combination of poor performance of underlying stocks and investors pulling their money, to £3.7 billion. The straw that appears to have broken the camel’s back was the request from Kent County Council on Tuesday, which had approximately ~£250 million in the fund, to fully withdraw their money. It was at this point that the management at Woodford Investment Management felt they had to gate the fund.
So why are investors no longer able to get their money out?
The simple reason is because the fund was unable to meet the obligations of the withdrawal requests being made. Most funds and fund managers will typically retain a small cash buffer within their fund (typically a couple of percent of the fund) to be able to handle any withdrawals. Failing this, the manager can raise cash by selling down some of the underlying positions to then meet any redemption requests. And this is where, to some extent, Mr Woodford has come unstuck. The current composition of the Equity Income fund is unlike any other fund in his peer group. The fund has a sizeable weighting in small cap companies and “unquoted investments”. The position in these types of investments (as a percentage of the total fund) was perhaps smaller in previous years, but to satisfy the spate of withdrawal requests, Neil has been selling down his more liquid assets, which are typically those listed on the CBOE UK 100 (i.e. the largest UK companies), leaving more invested in these less liquid investments.
What are unquoted investments?
Unquoted investments are effectively shares in a private company that are not traded on a recognisable stock exchange. Because they are not traded, it is more difficult to value these companies – conversely companies listed on a stock exchange can be more easily valued as there is (more often than not) a price prescribed to the shares of these companies. Not only are unquoted investments harder to value, they are also far harder to trade. That is because there are less active buyers and sellers in the markets for these companies compared to, for example, BP shares, which are constantly being traded in massive quantities over an exchange.
Is Woodford Investment Management right to suspend withdrawals?
In a recent video release, Mr Woodford explained that the reason withdrawals from the fund were being temporarily suspended was “to protect the investors in the fund”. What he means by this is that by stopping any further withdrawals for a period, he does not have to liquidate any more of the fund to pay investors their money back. This may seem contradictory because not giving investors their own money back doesn’t seem like offering them much protection. However, there is logic to their decision. The cat is well and truly out of the bag that people are withdrawing their money from the fund and the market is now well aware that Neil needs to start selling the investments in his portfolio to meet withdrawal demands. The problem with this is that when everyone knows you are a forced seller, they aren’t going to offer you top dollar for whatever it is you need to sell. This is true not just in investment markets, but all markets. Having to accept a lower offer for these investments would hit investors as the value of their investment in the fund would fall (as would the amount of money that would be received by those wishing to pull their money out of the fund). This can be reaffirmed by the fact that hedge fund managers are now shorting (i.e. betting that the price will fall) the companies that Neil has the largest exposure to in the fund.
By temporarily suspending withdrawals, Neil has more time to slowly unwind his positions in the illiquid investments and increase the cash buffer to meet redemptions once the suspension is lifted.
So should investors avoid illiquid/unquoted investments?
Not at all. To go back to the fundamental basics of investing, one of the primary aims of investing money is to try to generate returns in excess of cash. To generate these returns, investors place their money into different types of assets which each have several types of risks. These are the additional risks (compared to keeping your money in cash) that investors are being compensated for. There are several different types of investment risk, such as:
As we often say at Montage, we believe in a well-diversified portfolio. By diversification, we do to some extent mean investing in different asset classes (Government Bonds, UK Equities etc.), but we also mean being exposed to different types of risk, such as the ones mentioned above. Liquidity risk (the risk of investing in assets in which you may not always be able to realise your investment) is just another one of these risks and, in our opinion, should be used to some extent in portfolios to generate additional returns. The most recognised example of liquidity risk for investment funds would be property (we can all remember some property funds suffering the same ill fate as Mr Woodford as a fallout of the EU Referendum).
Does Montage currently own the Woodford fund?
In short, No.
When Woodford launched the fund in June 2014, the investment committee agreed to add the fund to the portfolios (having been invested in his fund at Invesco Perpetual). The fund enjoyed very strong performance in the first year. By August 2015, the committee had become concerned with the performance of the fund, because it had outperformed its benchmark and peers by a significant margin (it isn’t just funds that underperform that investors should worry about!). This prompted the committee to conduct some attribution analysis on the fund (a posh way of saying they reviewed what investments were causing all the good performance). What they discovered was that a significant proportion of this outperformance was generated from these unquoted shares. This was a concern to the committee as these companies are not as easy to value and (as can now be seen) if these holdings had to be sold, the value that would be realised may be very different to what the paper value is. It was because of this that the committee decided to sell the fund and replace it with the Evenlode Income fund (which they continue to hold).
This is not the first time a fund manager has had to take such action and it won’t be the last. It is of course frustrating for investors of the fund as they want peace of mind that they can have their money back. But with investment comes risk. We do believe that the actions being taken by Woodford are in the best interests of shareholders of the fund and that they will be better off in the long term by the management taking the decision to temporarily suspend withdrawals than if they just allowed redemptions to continue. How Woodford and his team come out of this on the other side awaits to be seen.