Former fund management 'star' Neil Woodford has been in the news recently as a result of the dramatic swings in value of the investment funds that he managed, whilst leading investment firm M&G have been under fire for closing down access to their commercial property funds. Does this mean that these are bad investments, or just a matter of poor timing? Richard Urwin, our Investment Director, looks at what went wrong...
Earlier this year the Governor of the Bank of England, Mark Carney, said investment funds that include illiquid assets but allow investors to take out their money whenever they like were “built on a lie”. He went on to say that the lie is “that you can have daily liquidity for assets that fundamentally aren’t liquid. And that leads to an expectation of individuals that it’s not that different to having money in a bank,” He cited this as a major risk to the financial sector.
I have to say that I found this amusing, I even had a little chuckle to myself as I read it. It isn’t that he doesn’t have a point about liquidity it was that he chose the example of money in a bank as being something which is liquid.
The Governor’s comments were made a month or so after a well-known fund, the LF Woodford Equity Income Fund, suspended redemptions. This followed a steady flow of redemption requests which gathered to a rush for the exits by investors seeking to take their money out. The suspension meant that investor's money is locked into the fund until further notice.
The Woodford Income Fund held a proportion of smaller illiquid and unlisted stocks. As Neil Woodford’s “value” investment style under-performed, fickle investors sought to withdraw. The bulk of the fund was invested in highly liquid large and mid-size company shares and billions of pounds worth of redemptions were met, but the diminishing gross value of the fund increased the proportion of illiquid stocks. A forced seller has to accept discounted prices. Performance worsened, redemptions increased, FCA rules around the proportion of illiquid stocks that can be held were breached, bad press ensued, redemptions increased further, hedge funds began to short some of the fund's positions and eventually the fund was gated.
That is to say that purchases and sales of units in the fund were suspended. That’s a very brief version of the Woodford story but it isn’t really the main point of this article. It’s helpful to understand the recent background to Mark Carney’s comments though.
“This is a big deal. You can see something that could be systemic,” Carney told MPs. “These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid. And that leads to an expectation of individuals that it’s not that different to having money in a bank,” he said.
I wonder how liquid the good people of Newcastle thought their money in the Northern Rock Bank was when queues began to form outside branches in November 2007.
If you recall, this was a harbinger of further liquidity issues for much larger banks and building societies in the UK and indeed globally. Banks are one of the most obvious examples of a liquidity mismatch that there is. That is why Mr Carney’s comments amused me so much. Banks lend long and borrow short. That is to say that they take in deposits and borrow in money markets usually with redemption terms of less than a year. They then lend long i.e. they lend money on repayment terms of multiple years. There is no bank on the planet that would not need to resort to central bank help in the event of sufficient of its depositors requesting their money back. Are banks built on a lie Mr Carney?
Actually I think they are built on trust just as the currencies of the world are. The system works as long as there is trust in the currency or institution. As soon as large numbers of investors begin to dump an open ended fund it has potential problems. These problems become insurmountable if it holds illiquid assets.
So does this mean that investors should avoid illiquid assets?
It has been reported that UK property funds saw a record 2.2 billion pounds withdrawn during 2019, equivalent to one in every £15 of assets under management. Usually the media will ascribe a rational economic reason to such happenings but more often than not mass redemptions simply reflect herd behaviour by investors.
Property funds were hit by outflows in the later part of the year well after the Woodford gating and Mark Carney’s comments. M&G and Prudential closed a number of their UK property funds towards the year's end. Other property funds sold down property raising substantial cash weightings. Transaction costs in commercial property are significant and selling prized assets into a weak market will not have been mangers' desired course of action but, other than gating a fund, there is no other option. Performance will of course have suffered.
In response to these events the BoE has made some suggestions for changes to fund pricing. These have been reported as complex and hard for investors to understand. The thing is there is no need for significant change; there already exists an ideal structure for investment in illiquid assets, it’s called an Investment Trust and its structure was around for many decades before open ended funds were popularised. There is nothing wrong with open ended funds for investment in highly liquid underlying holdings but when you are seeking to exploit the undoubted return premium that can be obtained from illiquid investments an investment trust is a far more appropriate structure. This just seems like school boy stuff to me.
There are so many mismatches of liquidity in the pooled investment structures many investors use these days but these only come to light when the lie is exposed. The bank runs of the Global Financial Crisis exposed the true nature of “cash in a bank” and it has to be said Mr Carney it isn’t always that liquid. Woodford believed a little too much of the hype that surrounded him. He was a great stock picker, proven over many decades but he placed too much confidence in the faith of his investors. His funds grew quickly, buoyed by positive publicity, reputation and Hargreave Lansdown’s infamous buy lists. He didn’t account for the fickle nature of this money, for the lemming mentality of the herd and his overconfidence did for him and his investors.
Property funds suffered high redemptions and closures after the 2016 referendum and, lo and behold, as the Brexit Election loomed investors rushed for the door again. Not because of a view that the fundamentals of their underlying investments had changed but because they thought other less smart investors would also rush for the exits. There are surely sufficient examples of this very human behaviour in the non-financial news for us all to recognise it as a fact.
I could list many potential liquidity mismatches but I think the one in the retail space which has the greatest potential for regular blow ups is commercial property. Why anyone would invest in such an obviously illiquid investment via an open ended fund is beyond me. Property is a great asset class and one which features greatly in our portfolios but there isn’t an open ended property fund in there.
I would hate to be accused of appearing to be wise after the fact and have resisted requests to write an article or give comment on the Woodford situation, but I think there are fundamental lessons to be learned by investors in the events I’ve described above. Whilst I appreciate that this is no laughing matter for anyone caught up in this fiasco, nevertheless I still chuckle at Mr Carney’s comments particularly his inference that “money in the bank” is not a liquidity mismatch. It is, and therefore by his reckoning probably built on a lie. There have always been runs and there will always be runs.
At the end of the day, investment risk will always exist, but one way to mitigate this risk is to select the right investment vehicle or structure for each different asset class.
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