Rushman's Rants

The Myth of the Strong-Man Fund Manager

It is not Schadenfreude, but Neil Woodford’s headline-making problems have reinforced my conviction that we at Walden Capital invest our customers’ money exceptionally responsibly.  I certainly do sympathize with the large number of worried individual investors who are calling their advisors, wondering if their money is safe.  Here I want to explain why the Woodford Equity Income fund could never form part of Walden’s model portfolios.

Perhaps I should start by explaining the practice of gating or suspending a fund.  It means denying an investor access to their invested cash – literally shutting the gate to redemption requests – and it is commonly allowed by the small-print of an ‘open ended’ fund.  Gating gives the fund manager a longer time to sell assets that are difficult to sell.  The need to gate is inextricably bound up in the liquidity of the assets held in the fund – i.e. how readily tradable those assets are.  Gating is not desirable for the fund or its investors and it happens only rarely.  It is particularly unusual in a mainstream equity fund, endorsed as ‘high-quality’.

Now, if the delay in getting money out of fund were the only inconvenience, gating would not be so controversial.  In theory, all the investors will get their money, but they may have to wait.  However, in most cases of gating the assets that the fund is forced to sell to meet redemption requests end up achieving far lower prices than expected precisely because they are illiquid.  This means that everyone who was in the fund when it was suspended bear the cost of selling assets at a depressed price.  The delay is almost inevitably a harbinger of a fall in value that those held at the gate will eventually suffer when they are allowed access to their money.

This highlights something about illiquid assets.  Not only may they not be saleable in the same timeframe as investors need their money, but their pricing is unreliable.  By the very nature of illiquid assets, we cannot rely on frequent transactions to get a reliable read on a fair, market price.  The risk of fictitious pricing is clear when an asset shows unrealistic price development, with little or no volatility passing through to  the fund pricing.  It’s a risk we are on the lookout for when we research funds at Walden, and we rule out allocating to funds that do not show ‘believable volatility’.

So how are Walden clients protected from ‘the next Woodford’?  I see protection at three levels:

• Our overarching investment philosophy of using only liquid, maximally diversified, low-cost investments whenever possible.  Woodford’s funds fail to meet our criteria because they include significant illiquid components, are concentrated in securities picked by ‘superstar’ fund managers, and they have high-fees attached.  We simply wouldn’t consider a fund like this as a mainstream equity exposure.

• Our investment committee.  Every quarter, more frequently if markets dictate, we convene our 5 highly experienced (and opinionated) individuals to discuss what we might change in our portfolios.  One thing we talk about a lot is choice of investment components in our well-established model portfolios.  Liquidity is one of the most keenly observed properties of any investment choice we make.

• Our asset allocation.  The proportions of your overall fund invested in each type of asset are scientifically set and we set strict upper bounds on how much weight any particular investment selection can have.  Some asset classes, like property, are intrinsically illiquid and, despite robust discussion, we may select a fund with lower liquidity than we would like.  However, such asset classes are each never more than 10% of our model portfolios.  A liquidity problem in a relatively small part of our portfolio is a relatively small problem.

To those with money in Mr Woodfords funds – and to be clear, this doesn’t affect Walden’s model portfolios in any way – we sympathize for the inconvenience.  We often get asked why we do not believe in fund manager skill.  Woodford is a great example of why not.

Prof. Jon Rushman - 26th June 2019

 

by John Stirling