By ROBIN POWELL
This article was originally written for the Suitable Advice Institute.
The Woodford scandal is one of the bleakest chapters in the history of the investing industry. In the spring of 2017, Neil Woodford was still being fêted as a star money manager. The investment company that bore his name managed more than £15 billion. But two years late his Woodford’s flagship fund was suspended and within months Woodford Investment Management (WIM) collapsed.
Today hundreds of thousands of investors who had money invested with Woodford are still waiting to find out the full extent of the damage — and when, if ever, they might be compensated.
But a bigger and more important question is whether such a scandal will happen again. The answer, as things stand, is almost certainly Yes, and there are four main reasons why.
1. The pressure to outperform
More than anything, it was Woodford’s predilection for unlisted or illiquid companies that proved his undoing. He made his name backing large, safe companies, but he came a cropper trying to identify small up-and-coming ones, which of course are very much riskier.
One by one, firms like Allied Minds, Provident Financial, AA Group Prothena, Circassia, Capita and Purple Bricks delivered bad news, eventually stretching the patience of Woodford’s larger investors to breaking point.
Why have traditional fund managers like WIM and H2O increasingly been straying into areas normally dominated by private equity funds and venture capital firms? Because that’s that where their best chance of adding value lies.
Generating alpha in the public equity space is now extremely difficult. With early-stage companies, which are far less researched, and whose valuation is often largely a matter of personal opinion, it’s easier to outperform, or at least to give the impression that you’re doing so.
With the pressure on fund managers to outperform growing as the outflows from active to passive funds continue to swell, the temptation to focus on unlisted and illiquid stocks will only become greater.
2. Our need for heroes
The Woodford scandal has at least made people question the wisdom of using so-called star fund managers. But most investors — and alas many advisers and journalists — still want to believe in them.
Irrational though it is, such behaviour is far from unusual. Everyone loves a hero, but this “halo effect” is especially important when choosing someone to manage our life savings. As the psychologist Philip Tetlock once said, “we need to believe we live in a predictable, controllable world, so we turn to authoritative-sounding people who promise to satisfy that need.”
The investing industry understands this well. That’s why fund management companies spend a fortune every year perpetuating the star manager culture through PR and advertising. It’s also why the platforms and brokers love their lists of “best-buy” funds. Woodford is the most heavily promoted British stockpicker of all time.
Unless and until human nature changes, investors will always be attracted to personalities like Woodford, who appear to have a good record, a compelling narrative and the courage of their convictions.
3. Underfunded pensions
When we think of investing, we tend to think of retail investors, but institutional investing is far bigger, and, for fund managers, far more lucrative. No wonder Neil Woodford spent so much time courting large investors such as pension funds.
Fortunately for active managers with the right track record, the attraction is mutual. Why? Because pension funds are desperate for some outperformance. As people live longer, pensions need to fund retirements lasting many decades. At the same time, trustees face the challenge of eking out decent returns in an era of negative interest rates.
Some of Woodford’s biggest investors were pension funds. Kent County Council, for example, whose request to withdraw its money led to the Equity Income fund’s suspension, at one stage had £317 million invested with him.
In a new book on Woodford, When the Fund Stops by David Ricketts, pension fund expert John Ralfe says: “The corporate governance within the local government pension scheme is is absolutely dreadful. The people usually in charge of making decisions haven’t got a clue, and like the idea of having money to play with. But they are reliant on advisers.”
And why are investment consultants so keen on managers like Woodford? Because most have built their value proposition on their ability to spot winning funds, even though the evidence says that all they are doing most of the time is simply recommending funds that have outperformed in the past.
As Warren Buffett once explained, “no consultant in the world is going to tell you, ‘Just buy an index fund and sit for the next 50 years’.”
4. Insufficient regulation
The best hope for averting another Woodford scandal is tighter financial regulation.
After its consultation on illiquid assets two years years ago, the Financial Conduct Authority did help to improve awareness of the problem. But it has so far failed to address the issue of illiquid assets in UCITS funds, or the inappropriateness of open-ended funds as an investment vehicle for illiquid assets.
Perhaps we will see some progress at some stage, but the chances of that happening imminently are slim. After all, we’re still awaiting the outcome of the FCA’a official inquiry into the Woodford scandal.
Interviewed by the BBC shortly after the Equity Income fund was suspended in June 2019, by Lord Myners, the former fund management executive and City Minister, said:
“The FCA… look like the people in white suits in Line of Duty, the scene-of-crime inspectors who arrive after the damage has been done and did not anticipate what was happening.
“The regulator will give itself two years to carry out a review of what went wrong, and the same risks will continue of allowing illiquid assets to be put in portfolios that are treated as if they are liquid.”
Sadly, little has happened in the 19 months that have elapsed since Lord Myners made those comments to suggest his predictions were wide of the mark.
Only a matter of time
For all of those reasons then, it seems only a matter of time before we see another disastrous episode in the UK fund industry like the Woodford scandal.
The frustrating thing is that we do learn lessons when things go wrong eventually — but nowhere nearly fast enough.
The Evidence-Based Investor is joining forces with the London-based law firm Harcus Parker to try to win compensation for as many Woodford investors as possible.
Harcus Parker will shortly be lodging a collective claim against Link Fund Solutions, which was responsible for overseeing Woodford’s funds.
We are neither lawyers nor financial advisers, but we do believe that the case against Link is robust, and that this action has a good chance of succeeding.
If you would like find out more about joining the claim, go to WoodfordClaim.com.