In funds with a liquidity mismatch, the First-Mover Advantage is huge, as Woodford’s investors found out.
By Nick Corbishley, for WOLF STREET:
On Oct 15., it was announced that Neil Woodford’s flagship Equity Income fund (WEI), which has blocked redemptions since June, would be closed for good. And signs are emerging that the problems that bedeviled WEI may be spreading to the wider UK equity fund sector. Across all UK-domiciled funds, investors pulled £2.1 billion in September taking net outflows this year to £7.3 billion, according to data from Morning Star.
Here are the active funds that bore the brunt of the exodus:
- Standard Life Aberdeen’s flagship Gars fund, which saw outflows of £392 million in September and which is down £8.9 billion over the past 12 months, shrinking the fund’s asset base to £6.5 billion.
- Majedie, an £11 billion active equity boutique that suffered £269 million of redemptions, a monthly record.
- Lindsell Train, the largest managed UK shares fund, also registered a record £374 million of net outflows in September despite returning 25% over the first nine months of 2019. Confidence in the fund was hit by the decision in July of the UK’s biggest broker, Hargreaves Lansdown, to remove the Lindsell Train UK Equity Fund from its Wealth 50 Best List due to liquidity concerns.
- Invesco’s UK-focused funds, which suffered the biggest wave of redemptions in September — £967 million — and is down £8 billion over the past 12 months.
Invesco’s UK business was, ironically, managed, with incredible success, by Neil Woodford until 2013, when he left the U.S. firm to set up his own investment company, taking many of his Invesco clients with him. So formidable was Woodford’s reputation in the fund sector at that time that he was able to raise £10 billion in his first two years of going solo.
For Invesco, the opposite happened. Since Woodford’s departure, the firm’s UK-focused funds have leaked £15.4 billion. More than half of those funds were redeemed in the last year alone. Things were hardly helped when the two main funds — the Invesco High Income fund and Invesco Income fund — featured prominently in Bestinvest’s 2018 “Spot the Dog” report, which highlights the sector’s worst performers. In September, it saw its worst outflows since Woodford’s departure.
What appears to have spooked many investors is the fact that the man picked to replace Woodford, his protege Mark Barnett, appears to be following the exact same playbook of his one-time mentor. Like Woodford, Barnett has been placing massive bets on companies that are often difficult to trade. In total, Barnett has poured more than two thirds of the £6.1 billion Invesco High Income Fund into higher yielding but largely illiquid micro-, small-, and mid-cap stocks, up from less than a quarter when he took over in 2014.
As the collapse of WEI has shown, betting big on illiquid investments carries large risks for open-ended funds that, on the one hand, offer their shareholders the opportunity to redeem their funds whenever they want while, on the other hand, pouring those same funds into investments that can take weeks or months to sell.
It is this sort of liquidity mismatch that the Bank of England has been warning about for years. If investors in an open-ended fund decide to pull their money en masse, which they’re ostensibly allowed to do at just about any time, the fund could struggle to liquidate its assets in time if those assets are not very liquid. It’s precisely what happened at Woodford’s flagship fund, which saw its asset base crumble from £10 billion to £3.7 billion in the space of just three years, before the gates were slammed shut on the remaining investors in May.
This ability of investors to yank out their money at virtually the drop of a hat can create “an incentive [for them] to redeem when they expect others to do so,” said the Bank of England’s Financial Policy Committee (FPC) in July, adding that this mismatch in liquidity “has the potential to become a systemic issue.”
It’s not just the Bank of England that’s flagging up this problem; so, too, are EU regulators as well as senior figures in the fund industry. Amundi’s chief investment officer, Pascal Blanqué, recently warned that the asset management sector could be on the cusp of a wider liquidity crisis, as a result of the fears sparked by Woodford’s downfall. “This business is a trade-off between risk, return and liquidity,” he said. “We have the ingredients of looming liquidity mismatches across the industry.”
An added cause for concern cited by Blanqué is that banks have pared back their dealer and market making activity following the global financial crisis. Having scaled back the amount of risk they take, due in part to more stringent capital requirements from regulators, banks’ diminished ability, or willingness, to absorb liquidity demand during selloff periods could pose wider problems for fund managers.
The more that those fund managers stray into less liquid assets, in a desperate hunt for returns in a yield-starved world, the greater the threat this vulnerability could pose to financial stability. “We’ve seen a frantic search for yield on the buy side, pushed by [central banks’ quantitative easing programs],” said Blanqué. “The combination of a frantic search for yield, and the deterioration of market liquidity, can create mismatches.”
Such mismatches have already caused liquidity problems this year for London-based H2O Asset Management and Swiss-based GAM. Three years ago, in the aftermath of the Brexit vote, six commercial real estate (CRE) funds were forced to suspend redemptions for the same reason.
Now, those same mismatches have led to the downfall and disgrace of Woodford, one of Britain’s most revered stock pickers, while decimating the savings of hundreds of thousands of retails investors. It has also shone a bright spotlight on the dangers of entrusting one’s money with open-ended funds that, in turn, plow that money into illiquid assets.
It appears that many investors, now aware of the first-mover advantage with open-end mutual funds, and already leery about the risks of a no-deal Brexit and fearful that what happened at Woodford could happen to them, are making their way as calmly as possible to the exits. By Nick Corbishley, for WOLF STREET.