The Woodford Funds issue highlights yet another side effect of QE

by Shaun Richards

Yesterday saw a classic case of someone trying to close the stable door after the horse has bolted. Let me hand you over to Bank of England Governor Mark Carney in Tokyo.

System-wide stress simulations are currently being developed, including at the Bank of England, to assess
these risks. And authorities are beginning to consider macroprudential policy tools to guard against the
build-up of systemic risks in non-banks.

That brings two initial thoughts. Firstly central bank stress tests have become a target of black humour as banks pass and then fail. Next why is he mentioning this?

Over half of investment funds have a structural mismatch between the frequency with which they offer
redemptions and the time it would take them to liquidate their assets. Under stress they may need to fire sell
assets, magnifying market adjustments and triggering further redemptions – a vicious feedback loop that can
ultimately disrupt market functioning.

If you had read this without seeing the title of this article you would probably be now suspecting where this is going but let me put this in a different way. As a concept the description above makes such investments sound like a bank which gets a liability asset mismatch via lending long and borrowing short. This is not something which has got much of an airing even in the credit crunch era. There was one past episode but it was presented as being exceptional.

We have recently seen analogous situations in the UK within some niche managers and smaller markets, such as open-ended property funds investing in commercial real
estate.

Some of you may recall the phase when after the EU leave vote in the UK several commercial property funds had a rush of redemptions and needed temporary freezes or closures. Now this should not have been any great surprise by the nature of the investment as one can hardly sell a shopping centre quickly, so this was a known issue for this area and a reason to avoid it if you fear that. Some institutional investors I have dealt with are very careful they can get out of an investment before they get in. To give you an example of a past issue along these lines was a couple of decades ago when there was a fashion for investing on the Milan stock exchange. You see it later transpired it was a lot easier to get your money in than it was to get it out!

However conceptually Governor Carney suddenly seems to have released this is in fact a much wider problem.

These flows are particularly flighty , reflecting the fact that more than $30 trillion of global assets are
held in investment funds that promise daily liquidity to investors despite investing in potentially illiquid
underlying assets, such as EME debt ( EME = Emerging Markets )

What has triggered this?

From the BBC on Monday.

One of the UK’s most high-profile stockpickers has suspended trading in his largest fund as rising numbers of investors ask for their money back.

Neil Woodford said after “an increased level of redemptions”, investors would not be allowed to “redeem, purchase or transfer shares” in the fund.

Investors have withdrawn about £560m from the fund over the past four weeks.

Kent County Council also wanted to withdraw its £263m investment, but was unable to do so before trading halted.

There have been various issues here. The opening one is that Neil Woodford was an extremely successful fund manager meaning that when he went alone a lot of money was invested in his funds. However more recently his investments have lost that magic feeling, we looked at Provident Financial for example a while back and Purplebricks was another. As it happens Monday brought more trouble on that front.

Mr Woodford’s firm, Woodford Investment Management, is also the biggest investor in Kier Group, the construction and services group which on Monday warned on profits, sending its shares crashing 41%.

Obviously there is an issue of selling into falling markets but there is a deeper one which is the way that there were investments in illiquid ones. There is a limit of 10% for this in OEICs or Open Ended Investment Companies a boundary which was approached and this causes trouble as a fund shrinks. If you sell the liquid shares then the illiquid ones grow in relative terms and things become more unstable. What could go wrong?

Financial Conduct Authority

You might be wondering what our regulator has been doing here. On Tuesday Andrew Bailey was interviewed by Bloomberg TV and this is how they summarised it.

FCA CEO Andrew Bailey says they are “closely watching” Neil Woodford’s fund plans

I would imagine that pretty much everyone is thinking they look to have been asleep at the wheel. But if you watch the interview he made the statement that it is better that illiquid assets are in the non-bank world than in the bank world as we wonder if a game of playing pass the parcel has been taking place? Banks are “resilient” because the problems have been moved elsewhere?

Care is needed with this we do need investment in things which are illiquid such as new start-ups. So this in itself is not the problem to my mind it is that the risks should be made clear. On that road the FCA has been asleep because income funds have been considered low risk whilst in fact being allowed to run a high risk strategy. Putting that another way someone might consider them as being a fund for close to and at retirement when we now see that can be simply untrue.

There has also been another problem. From Reuters.

The FCA indicated on Wednesday that it was concerned the movement of some or all of Woodford’s stake in four companies to Guernsey might be an attempt to side-step rules capping the share of unlisted stocks in his fund at 10%.

Where was it when this was happening? It now seems to be engaged in a bit of tit for tat finger pointing with the Guernsey authorities along the lines of this from Lily Allen.

It’s not fair and I think you’re really mean
I think you’re really mean, I think you’re really mean

Comment

There is in my opinion something missing from the debate and well might the Bank of England look away from this. It comes if we look back and take a once in a lifetime opportunity to ask this question.

You may ask yourself, “Well, how did I get here?”

Seeing as it along with the other central banks has chopped interest-rates and yields via all the reductions and bond purchases they have crippled the old concept of investing for income. It was only yesterday we were observing that Germany has a benchmark yield of -0.23% and the UK Gilt equivalent is 0.86%. So how do you offer a yield of say 4% plus a capital gain? Plainly you have to take more risks than in the past.

There is an irony as we note the role of “The Precious” here. There was a time when in the UK the banks offered what was perceived as a safe dividend yield ( younger readers I am asking you to trust me on this,,,,,) and were a staple of this sort of investing strategy. Not only has that gone but the consequences of that is the low,no and negative yield world in which we now exist.

So the people who are supposed to protect us are the ones who in fact have contributed to the problem as we ask one more time.

Quis custodiet ipsos custodes? ( Juvenal)

In the interests of full disclosure I wrote a piece for the Woodford blog a few years back predicting that the next move from the Bank of England would be an interest-rate cut.

 

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