Case of besieged fund offers lesson in style drift and liquidity risk

A look at its factor exposures reveals that troubles with investor redemptions have been a long time coming

Case of besieged fund offers lesson in style drift and liquidity risk

Investors and their advisors consider many factors when it comes to choosing an investment fund to select in their portfolio. Aside from an investor’s risk tolerance and sensitivity to costs, they must also pay attention to a fund’s objectives, its stated investment strategy, as well as the record of the manager at the helm.

But as a recent case from the UK shows, fund investors can’t expect any guarantees even based on its manager’s stellar history or its stated investment objective. On June 3, one of the country’s best-known stock-pickers issued an apology to investors after he suspended trading in his largest fund, from which 560 million pounds (nearly C$1 billion) had been withdrawn over the four weeks prior.

“As difficult a decision as this is, and clearly frustrating for you, our investors, we felt this was necessary to protect your interests,” said Neil Woodford, who manages the Woodford Equity Income Fund, as reported by BBC News.

Redemptions from the fund had accelerated as a result of very poor performance, something that many did not expect from Woodford’s past record. During a long stint as a fund manager at Invesco Perpetual, he saw success from picking unfashionable stocks in areas such as tobacco and avoided the dotcom boom. He set up his own firm in 2014, and many clients followed; The Economist has reported that Woodford Investment Management had over 10 billion pounds (nearly $C17 trillion) in assets managed at its peak.

But as often happens with investors picking stock-pickers, those who put their faith in Woodford got burned. He has come under heavy scrutiny in the wake of his decision, particularly as the fund has failed at its objective to “provide reasonable level of income together with capital growth.” He has defended the fund against criticisms, saying in a recent letter to investors that “every asset in the portfolio has a fundamental value that significantly exceeds its share price.”

But an analysis conducted by experts at MSCI revealed that the fund had drifted from its original objective — and had been doing so for some time. “Six months before the Woodford Equity Income Fund suspended withdrawals on June 3, the level of illiquid securities stood close to 80% of assets,” said a recent commentary from MSCI.

Using MSCI’s factor classification standard (MSCI FaCS), analysts at the firm examined the fund’s style characteristics from March 2015 to December 2018. They found that the portfolio had substantial negative exposure to value, size, momentum, and quality, and had only neutral exposure to yield. In other words, the fund held securities “with average income-generating characteristics, high valuations, negative price trend, poor quality characteristics and low size” — and those factor exposures drifted to become more extreme over time.

The fund also failed at its aim to provide high liquidity as an open-ended mutual fund. It held substantial investments in unlisted securities and securities outside the MSCI ACWI IMI, which is designed to represent the investable opportunity set for large-, mid- and small-cap equity securities in developed and emerging markets. The problem was compounded by substantial investor redemptions, which caused the share of unlisted and illiquid securities to increase.

“As the fund sold the listed positions, the unlisted part of the portfolio reached 18%, well above the U.K.’s Financial Conduct Authority’s regulation limiting funds’ unlisted holdings to 10%,” the MSCI analysts noted. ” While investors focused on the unquoted positions and how the manager was moving most of them to a trust, the fund’s allocation to listed, but highly illiquid, securities soared.”


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