This may sound like an odd observation, but, in effect, Neil Woodford came unstuck because he turned his giant equity income fund into a bank. Not literally, of course, but in certain, important ways, the parallel holds. Banks take in customer deposits, most of which can be withdrawn without notice (like any open-ended fund that offers daily dealing), and they lend those deposits out as loans and mortgages that can take 25 years or more to be repaid. If too many people ask for their savings back at the same time, the bank goes pop, à la Northern Rock.
Put that way, it’s hardly surprising that Mark Carney, governor of the Bank of England, has strong views on open-ended funds. “These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid,” he told the UK Parliament’s Treasury Select Committee in June 2019. “And that leads to an expectation of individuals that it’s not that different to having money in a bank.” Observant readers will note that Carney, in effect, admitted that banks are also built on a lie, but let’s move swiftly on for the moment.
Why, then, did disaster strike Woodford’s funds? The answer everyone is talking about is liquidity, or the lack of it. This is certainly one aspect of the answer, although I think there are other lessons from this too.
But to begin with the obvious reason: this happened because the rules permit it. Open-ended funds like Woodford’s can hold up to 10% of their portfolio in illiquid assets. Once enough investors start to flee, there’s no choice but to sell the most liquid stuff to release cash. This necessarily increases the weighting of the more illiquid holdings that are left behind, eventually tipping the fund over the 10% limit and making it non-compliant. As it struggles to meet redemptions and breaches the regulations, it will have to lock in the remaining investors’ money and restructure itself.
In search of returns
That, though, begs the question of why an open-ended fund would choose to hold assets that could get it into this kind of trouble. The explanation lies in the financial world’s search for higher returns from illiquid investments, which runs far wider and deeper than Woodford’s fund. Uninspired by the returns on offer in liquid, public markets, many investors have chosen instead to seek an ‘illiquidity premium’ from holding non-traded, private assets: from commercial property and private loans to essential infrastructure and unquoted, early-stage companies.
Daily dealing seems a clear case of telling investors they can have their cake and eat itThis trend is based on the idea that we can earn a higher return from assets that are illiquid and therefore hard to sell in a hurry precisely because we accept the risk that we won’t be able to get our money back whenever we feel like it. Looked at that way, Carney’s stance is justified: daily dealing seems a clear case of telling investors they can have their cake and eat it.
The idea of investing to earn an illiquidity premium goes way back, notably to David Swensen, manager of the huge Yale endowment in the US. And for that kind of institution, and increasingly insurers’ pension investments, it makes sense. They must pay out an income for many years into the future so it doesn’t really matter that they can’t sell the assets that are providing that income at the drop of a hat. They don’t need to – they need the income to keep coming in.
But the same cannot be said of funds offering daily dealing. That’s why ideas are gaining ground, such as requiring investors to accept either notice periods for redemptions or discounts on the value of their holdings in return for instant access. Changes like this would make a lot of sense.
A second problem
Woodford’s fund wasn’t purely an issue of vanishing liquidity, though – it was also caught out by a second major problem. Not only did he have large illiquid holdings (early-stage, private company shares), but he also held investments in companies whose shares are theoretically liquid, such as Alternative Investment Market (AIM)-quoted stocks, but that in his hands were anything but. This is because he bought such large stakes in these companies: 25%-plus holdings were not uncommon. Stakes this large are almost impossible to sell quickly, no matter the market conditions.
As a result, his portfolio was in fact much more concentrated than a list of its shareholdings might have suggested – but the concentration lay in its very high exposures to individual underlying stocks. For other investors in those mainly AIM-quoted companies, the results have been brutal – prices have crashed because the market knows the number one shareholder is a forced seller.
So, the effects of this blow-up ripple out beyond the investors with money trapped in the fund. And they show that it is not just portfolio liquidity that regulators need to ponder, but portfolio concentrations.
This article first appears in the October 2019 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.
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