With redemptions suspended in the Woodford Equity Income Fund, Mark Latham examines the issues the debacle has thrown up.
In today’s environment of ultra-low interest rates, adding a small proportion of unquoted assets to investment portfolios has been increasingly used to boost alpha. Lately, however, fears about the liquidity risk of such holdings have prompted investors to pull billions from Woodford Investment Management (IM).
The firm, founded by the once-feted Neil Woodford (pictured below), suspended redemptions in the LF Woodford Equity Income Fund (WEIF) in June, raising profound questions for the industry. Across the front-to-back-office chain of a fund house, what are the implications of an emergency gating? How will this affect distributors? And are we about to see a kneejerk reaction from regulators?
The decline and fall of the WEIF was as sharp as it was sudden. From total assets under management of £8.2 billion (€9.1 billion) at the end of 2017, it almost halved in value to £4.6 billion by the end of last year. And by the time Woodford IM’s five-year-old flagship fund was gated – to stave off an investor exodus – assets had plunged even further, to just over £3.7 billion.
What triggered the crisis in June was Kent County Council’s attempt to withdraw a £263 million mandate. Woodford IM’s dramatic response prompted Hargreaves Lansdown, the UK’s largest fund supermarket, to remove the WEIF, along with the smaller Income Focus Fund, from its best-buy Wealth 50 list.
In parliament, the influential chairperson of the House of Commons’ Treasury Select Committee, Nicky Morgan, wrote to Hargreaves Lansdown – which had received discounts from Woodford IM – asking the firm to explain the inclusion of the WEIF in its best-buy Wealth 50 list “until a short while ago”.
During the furore, the UK’s largest wealth manager, St James’s Place, announced it would terminate its relationship with Woodford IM, which has since warned staff that jobs are likely to be cut. Meanwhile, the UK’s financial regulator, the Financial Conduct Authority (FCA), warned that it could open an investigation should there be evidence of “serious misconduct or non-compliance with the rules”.
The FCA confirmed it had been in discussion with Woodford in the months leading up to the gating and had also been in talks with the Guernsey stock exchange, where some of the fund’s assets are listed. “Listing something on an exchange where trading does not actually happen, as far as I can see, does not actually count as liquidity,” FCA chief executive Andrew Bailey pointedly told Morgan’s committee.
Bailey, as well as Morgan, subsequently called on Woodford IM to waive management fees (believed to amount to some £100,000 a day) on the frozen fund. These calls were ignored.
Perhaps the strongest criticism of all, however, came from the Bank of England, whose governor Mark Carney described funds promising daily redemptions while investing in illiquid assets as “built on a lie”.
“That leads to an expectation of individuals that it is not that different to having money in a bank,” he told the Treasury Select Committee last month.
Nevertheless, despite the criticism from investors, regulators and politicians, WEIF’s unquoted investments contributed 37% of the fund’s positive performance between its launch in June 2014 and the end of February.
Founding partner Neil Woodford, who became one of the UK’s best-known stock-pickers during a career at Invesco Perpetual, claims that the lock-down of the WEIF is needed to buy time to restructure the fund, is in the best interest of investors and is the only way to avoid a fire sale of assets.
As outflows mounted (averaging £10 million per business day in May) and the fund’s quoted holdings were sold to meet redemptions, this unavoidably pushed up the proportion of the fund held in unquoted assets.
The issue of the “liquidity mismatch” manifested itself again last month when the London-based (but French-owned) H2O Asset Management boutique, which specialises in government and corporate bonds, was reported to have lent extensively to smaller businesses through bonds that are less liquid. The revelation led to shares in Natixis, H2O’s parent company, tumbling more than 10%.
As with the Woodford debacle, H2O’s holdings of less liquid assets raised questions over whether, in a fund where clients were theoretically supposed to be able to withdraw and deposit money daily, buyers could be found quickly and at a good price should the bonds need to be sold.
A substantial exposure to illiquid assets was also one of the factors that led to the Swiss asset manager GAM gating its Absolute Return Bond fund range last year.
Patric Foley-Brickley, managing director at asset servicing firm Maitland, believes that fund administrators who offer the fiduciary oversight services of an authorised corporate director (ACD) will be examining the Woodford debacle to see what lessons can be learned.
He points out that the WEIF’s fund prospectus makes it clear – as did the key investor information document or KIID (a simplified description of the fund aimed at non-professional investors) – that it would invest in unlisted companies as well as overseas entities.
Investors were also clearly warned that “there may be occasions when there is an increased risk that a position cannot be liquidated in a timely manner at a reasonable price”.
In addition, potential investors were told that the fund intended to invest in small companies; and that this would involve higher risk and be subject to greater volatility than investing in well-established blue-chip companies.
The breaches of the 10% limit of holdings in unlisted securities were almost certainly “inadvertent” when they first occurred, rather than “advertent”, Foley-Brickley says. This is important, as a fund that inadvertently breaks above the 10% limit imposed by EU Ucits rules is permitted up to six months to wind down the position. By contrast, an “advertent” breach of the limit would require a fund to take immediate action to reduce the holding of unapproved securities. It could also be required to provide compensation to investors.
“What may have been a very acceptable 3%, 4% or 5% exposure in unapproved securities has, because the fund value has come down so rapidly, shot up proportionally above the 10% limit,” says Foley-Brickley.
“However, there is no doubt the fund has underperformed, and it appears that many people invested into the Woodford fund based purely on his reputation and 27-year track record, without giving due regard to the investment policy and risk warnings set out in the fund documentation.
“But performance has been disappointing, and inevitably if you don’t perform, people are going to take their money elsewhere – and it is the rate of redemption that has caused the issue to escalate to this point.”
The decision to suspend will not have been taken lightly, says Foley-Brickley. “However, once you suspend a fund, its marketability going forwards will be challenging and, particularly when combined with the publicity that this fund has had throughout its lifecycle, may undermine the long-term viability of the fund as a whole.”
Shiv Taneja, founder and chief executive of the Fund Boards Council, a professional members organisation that promotes good governance on fund boards, believes the fiasco has thrown open serious issues around the governance of funds.
“The Woodford situation is an extreme example of how desperately wrong things can go when there is either an absence of governance or when organisations don’t do what they are supposed to do,” he said.
“This was the perfect storm around regulation and the governance of asset management. Things couldn’t really get any worse where you have a situation where a distributor acted as a sort of cheerleader for the fund manager, possibly at the cost of a lot of their clients’ money.”
Taneja believes there has been “a complete breakdown of multiple sets of actors”, with failures at four levels: the regulator (the FCA), the external outsourced governance team otherwise known as the ACD (Link Asset Services), a distributor (the online broker Hargreaves Lansdown, whose clients held 31% of the gated fund at the end of 2018) and Woodford IM itself.
“I think each one of them has got to take responsibility for certain things that they ought to have done and didn’t do that could have mitigated risks,” he adds.
Asked whether the 10% cap on unlisted securities is reasonable, Taneja replies that the question of whether there should be a cap of 5%, 10% or 15% “is as much an academic, intellectual and technical discussion as a governance one per se”.
“The regulation as it stands is very clear about open-ended mutual funds operating on the basis of daily pricing. The question then is to what extent should you allow them to hold illiquid assets?
“If somebody wants exposure to higher levels of risk, then why not just buy a closed-ended fund, an investment trust, for instance, and you could have all the risk you like without the issues around gating.”
Taneja believes that the relationship between Woodford IM and Link Asset Services – whereby Link provided a fiduciary service to Woodford as part of a commercial arrangement – throws up key questions that will need to be addressed sooner rather than later.
“I see an inherent tension in that relationship,” he says. “How can one company exert fiduciary responsibility upon another if it is being paid to do so? This is very different to other forms of investment management outsourcing, which tend to be largely transactional, and not about the more nuanced issue of governance.”
Hargreaves Lansdown’s role as distributor and the basis on which its best-buy lists are drawn up, as well as “the extent to which Hargreaves Lansdown came across as a cheerleader for Woodford”, should also be scrutinised, Taneja believes. This is because it is not clear to investors whether these lists were put together purely on the basis of performance or whether some commercial element (such as the offering of discounts) formed part of the equation.
Hargreaves Lansdown says that an explanation of how it chooses funds, along with a sector by sector performance analysis of the Wealth 50, is published on its website.
Stephen Elam of London-based law firm Cooke, Young & Keidan believes that the Woodford debacle should prompt investment brokers to “review and stress-test their relationships with funds”. He says: “The scale of Hargreaves Lansdown’s investment in Neil Woodford’s funds is staggering – it has, broadly speaking, been responsible for around one-third of cash inflows.
“Clearly, many brokers will not have the same scale, but where the relationship between broker and fund is so entrenched, and the fund’s performance becomes reliant on the broker’s continued support, it will become increasingly difficult for the broker to meet its obligations to act in its clients’ best interests.
“If a broker could not, if required, safely redeem its clients’ holdings in full, can that obligation really be met?”
Elam thinks brokers should review due diligence and have structures in place to execute resulting actions promptly. “The concerning levels of unlisted assets within Woodford Equity Income had been apparent for some time and the impact upon liquidity was entirely foreseeable – certain brokers had taken action but Hargreaves Lansdown had not,” he says.
“Litigation risk for brokers will depend upon the services offered and, importantly, whether investment advice was given.”
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