Neil Woodford’s woes expose a flawed investment model

Sitting in his offices near Oxford in the spring, Neil Woodford, Britain’s best-known fund manager, was already feeling tetchy. Asked in an FT interview how long his main investment fund could withstand the rate of outflows it was then seeing, he snapped sarcastically: “Presumably, we’ll be out of business in about two and half years.”

That doomsday prediction — like so many of Mr Woodford’s more recent investments — now looks hopelessly optimistic. Barely two and a half months later, the fall from grace of the one-time star stockpicker is all but complete.

Kent county council’s decision last Friday to pull £263m from his Equity Income fund triggered panic, prompting Mr Woodford to bar all withdrawals. His investment empire — which includes two open-ended funds and a listed investment trust — now manages less than £5bn, down by half in a matter of months. That includes the £3.7bn left in the stricken Equity Income fund which only two years ago boasted £10.2bn.

“Is he completely dead in the water?” asks one former supporter. “Probably, yes.”

On the face of it Mr Woodford’s travails might appear a very British story. A multi-millionaire investor who keeps a stable full of horses and has a penchant for equestrian eventing, he was a feature of the tabloids as well as the business press.

But the potential downfall of Mr Woodford, whose record once gave him a Warren Buffett-like status among a large following of retail investors, has sent reverberations throughout the investment management industry.

In a world of ultra-low interest rates, the drama this week around his investment fund demonstrates the risks of placing too much faith in the skills of a star fund manager to continuously beat the market. They are also another blow to the case for active investment management after a decade when the sector has been relentlessly undermined by the growth of passive funds.

“He’s a has-been. He’s part of an age that’s passed,” says a senior executive at one of the world’s biggest asset managers.

Mr Woodford’s credentials as a bold and successful stockpicker were established during a 26-year career at asset manager Invesco Perpetual. Five years ago that record emboldened him to go it alone — though from the start there were signs that Mr Woodford’s belief in himself could easily turn to hubris.

At a 2014 launch party, he invited dozens of fans and backers to Langan’s Brasserie in Mayfair. In an industry known for excessive charges and obscure investment practices, he made an admirable pledge to charge lower costs and be fully transparent. But Mr Woodford talked, too, about a keenness to create a legacy, comparing himself with the iconic 19th-century financier John Pierpont Morgan, whose group today dominates global banking.

“Never buy a fund named after someone,” says Gerry Grimstone, until recently chairman of rival asset manager Standard Life Aberdeen. “[You get a] total failure of risk control.”

With just a handful of staff at the start and Mr Woodford’s name on the door, money began pouring in, including a £3.5bn mandate from St James’s Place, the wealth manager with which he had enjoyed a close relationship at Invesco.

Mr Woodford’s record initially appeared to benefit from his new-found freedom. The Equity Income fund comfortably beat its benchmark and much of its peer group in its first year, and financial advisers urged their clients to invest.

The bigger the fund, the wider Mr Woodford began to look for investment opportunities. He took an increasing number of punts on unquoted stocks in the hope of benefiting when they finally listed. He also bought bigger stakes in small and midsized companies, especially biomedical businesses. This was a big departure from the unloved blue-chip companies on which he had built his stockpicking reputation.

The scale of the losses

He has often behaved, says one critic, “like a slightly milder-mannered Philip Green” when engaging with companies he bought into: just as the retail magnate might bawl out anyone who crossed him, so Mr Woodford would get “really, really angry” with a chief executive who was shifting strategy away from his idea of how a company should be run.

But the freedom to operate as his own boss, and without restraint, proved a key element of his difficulties. At Invesco, he was part of one of the biggest fund managers in the world with layers of compliance staff to keep his more adventurous instincts in check.

At Woodford Investment Management, however, dissenting voices were ignored and those who questioned Mr Woodford’s strategy or methods of running his portfolio did not last long. A succession of compliance staff passed through the business.

As many of his top picks foundered, bankers say Mr Woodford became increasingly irritated with his investments. The performance of the Equity Income fund in particular suffered in late 2017 and into 2018, prompting investors to demand the return of their money. To meet these redemptions, Mr Woodford was forced to sell the most easily tradable stocks, leaving a larger portion of unquoted shares and hard-to-sell stakes in small companies.

Soon the Equity Income fund was coming close to a 10 per cent limit on investing in unlisted companies. In a desperate attempt to avoid breaching the rules, Mr Woodford devised clever schemes to reduce the illiquid portion of the portfolio. These included switching £73m of unquoted stocks into an investment trust Mr Woodford also ran, called Patient Capital Trust.

Another workaround involved listing stakes in a handful of private companies on the lightly-regulated Guernsey Stock Exchange. This technically meant they counted as listed, and theoretically liquid, investments, although in reality they were not traded as Woodford was the only holder.

The Financial Conduct Authority has since said it is taking a closer look at the Guernsey listings, adding: “Where the FCA believes there are circumstances suggesting serious misconduct or non-compliance with the rules it may open an investigation.”

The tipping point for the Equity Income fund came last Friday when one of Mr Woodford’s longstanding institutional investors, Kent county council, decided to ask for its £263m back. That request, which came on top of the £10m flowing out of the fund every business day in May, overwhelmed the fund manager, leaving Mr Woodford no choice but to freeze the fund.

Hours later Hargreaves Lansdown, the UK’s most powerful retail stockbroker, dealt him another body blow by cutting the fund from its closely followed Wealth 50 list of favourite funds.

The Wealth 50, a revered best-buy table for the company’s 1.1m individual investors, had helped create the cult of Woodford. At the last count, in March, Hargreaves customers accounted for around a fifth of Mr Woodford’s assets under management.

Hargreaves’ decision was followed two days later by an even bigger blow when St James’s Place pulled its £3.5bn investment mandate, delivering what one financial adviser calls a “terminal” blow.

Although Mr Woodford’s style of investing may have been idiosyncratic, his potential implosion has also damaged many of the underpinnings of the active management sector.

The affair has once more demonstrated a fundamental flaw with open-ended funds that invest in illiquid assets — a problem exposed in 2016 after the UK’s Brexit referendum vote spooked real estate markets. When retail investors tried to withdraw from property funds, they were blocked when “gates” were imposed. The UK government and the FCA have yet to decide on how the rules should be changed.

The Woodford blow-up has also drawn attention to the cosy relationships between some managers and the investment platforms that market their funds to retail investors. Hargreaves, which secured a bigger discount on fees at his funds than its rivals could offer, continued to support Woodford despite the recent record of poor performance.

In some eyes, these close links could represent a mis-selling scandal in the making. “Hargreaves was hopelessly conflicted,” says a senior executive at one broker. “They were incentivised to promote products that were best for them and not the consumer.”

Mike Barrett, director of the Lang Cat, a financial services consultancy, argues: “By relentlessly marketing ‘star’ fund managers and ‘best buys’, platforms should be required to take more responsibility for the behaviours they are encouraging.”

Hargreaves says its customers benefit from the discounts it negotiates with investment funds, and that all of its fund research involves “stringent” quantitative and qualitative analysis. It only highlights managers “with great stockpicking talent”.

Amin Rajan, chief executive of consultancy Create Research, says Mr Woodford is a victim of “fickle investor sentiment”, adding: “The City is often accused of short-termism. Woodford took a road less travelled: he backed companies who could be tomorrow’s stars. Events conspired against him.”

Mr Woodford’s ambition for full transparency on his holdings may have been enlightened, but recent weeks have shown the risks of such openness. Short sellers have been able to exploit his difficulties, driving down the prices of investments they know he will be under pressure to sell.

Most of all, though, the Woodford affair has provided further evidence that star fund managers are a dying breed in an era when investment is increasingly managed by machines that track benchmarks.

In rising markets, even leading active fund managers too often underperform. Only the next downturn will prove how valuable they are in falling ones — although by then it might be too late for Mr Woodford to prove his mettle.

Additional reporting by Peter Smith and Jim Pickard