Neil Woodford, fund managers, and the systemic risk to the financial system

Andrew Bailey © Getty images
Andrew Bailey doesn’t need any more awkward questions at the FCA

If you have been watching the Neil Woodford saga unfolding over the last few weeks, you will know that the consequences of Woodford being forced to gate (prevent withdrawals from) his flagship Woodford Equity Income Fund are many various and increasing in number. The immediate consequences, of course, are for the  investors currently trapped in the fund.

They aren’t being treated particularly well by Woodford, who, having lost them a whole pile of money, is now – in a maddening exemplification of the asymmetric incentives baked into fund management – refusing to cut the management fee on his fund. He made a fortune from fees in his good days (his equestrian estate cost him over £13m before he started on the improvements); he’s clearly determined to make as much as he can from his bad days, too (the fund is generating around £100,000 in revenue a day). It is all insanely irritating.

Woodford has tainted his investment trust too…

But the miseries don’t stop there. Next up are investors in the Woodford Patient Capital Trust (LSE: WPCT), its board. According to The Times, one investor in the trust, Seneca Investment Managers, has been approaching others (possibly including BlackRock, L&G and Quilter) in an attempt to “force changes” to the five-person board with a little “shareholder action”.

The board is not seen to be fully independent by the market: the chairwoman, Susan Searle, once ran Touchstone Investments, “an intellectual property business taken over by IP Group, a listed VC firm with ties to Mr Woodford”. Another director is head of a pharmaceuticals group 24% owned by Woodford funds, and yet another is chief exec of Nexeon, a company in which the trust is also invested.

There is a lot of cosiness about. The market capitalisation of the trust has fallen from £800m in 2015 to a mere £530m and the shares are down 20% since the Woodford Equity Income Fund was shut. As a result, last week, the trust was forced to write down the value of its holding by £27m in one day, though they did say that “not in connecting with any sales by any other Woodford mandate”.

Hmmm. Either way, the shares are significantly off their 100p launch, and at 58p, they are trading at a 30% discount to the stated net asset value (which might or might not be accurate – the kind of unlisted companies the trust holds are very hard to value). It doesn’t end there.

The Patient Capital Trust business has a knock on to the investment trust industry. On the face of it, Woodford’s very public demonstration of why it is a really bad idea to hold illiquid stocks in an open-ended investment vehicle should be brilliant for the sector – suggesting as it does that anyone interested in the long-term growth on offer from private or small companies should definitely get their exposure via an investment trust (one in which you can always sell your shares). But to want to buy and hold investment trusts for the long term, you need to trust their directors to protect your capital for you. Have the board of the Patient Capital Trust done that? Not yet.

They should not have let Woodford swap illiquid assets in the income fund for a stake in the trust a few months ago (too dodgy looking) and they should not have given in and allowed him to sail so close to the regulatory wind by listing some of their top holdings on the Guernsey exchange to try and save the liquidity ratio of the Income Fund (also dodgy looking).

Alistair Osborne, writing in The Times, is not impressed. Searle he says has been presiding over “a conflict-ridden board that’s been exposed as being asleep on the job”. Time for them to make fact out of rumour perhaps and dump Woodford as manager of the trust?

…and the reputation of Hargreaves Lansdown

Next up in this miserable game of consequences is the brand reputation of Hargreaves Lansdown (HL), an organisation that has got away with overcharging its customers for years (sometimes a little, sometimes a lot) thanks to its ease of use, reputation as the champion of the retail investor, and brilliant customer service. The Woodford debacle is not a good look for the firm – nor are the regular newspaper articles about the bonuses of its bosses.

CEO Chris Hill has, for example, said that he will defer his bonus until the Woodford fund reopens. But getting his £2.1m slightly later than planned isn’t doing it for investors; they’d prefer he scrapped his bonus and had a think about also scrapping exit fees for anyone wanting to move their money from his firm. That’s particularly the case given that we now know that Hargreaves Lansdown had been having regular calls with Woodford over his liquidity crisis since 2017 (in November 2017, it made him promise that he “would make no new investments into unquoted businesses”, says the FT). But it still kept his fund on its best buy list.

It might have taken it off now, but its clients will be reminded of its post-pony-bolt closing of the stable door by the most recent edition of its house magazine, the Investment Times, in which Woodford features prominently. Hargreaves Lansdown says it regrets the “distress, uncertainty and inconvenience” caused to its clients as a result of its investments with Woodford. So it should.

Next there are all the other companies invested in the same firms as Woodford. Several fund managers have told me over the years that they haven’t been buying stuff Woodford holds just in case of a liquidity driven fire sale (his stakes were too large for comfort). Not everyone was so smart. Spare a thought, says the FT, for Lansdown Partners and for Invesco, both firms that hold many of the same investments as Woodford and are suffering as a result.

The regulators aren’t off the hook, either

There are also likely to be consequences of some kind for the regulators here. The Financial Conduct Authority (FCA) now says that the liquidity breaches of Woodford funds were raising red flags in early 2018. Some might think that the FCA might have stepped in sooner – particularly given the profile of Woodford’s investors.

In most trouble here might be Andrew Bailey, head of the FCA. He has been appearing in front of the select committee as part of a series of regular hearings on the FCA’s work. But, as the FT points out, the stakes for Bailey are “particularly high” at the moment. He is one of the frontrunners to replace Mark Carney as the governor of the Bank of England. The thing he doesn’t need is everyone asking awkward questions about the role of the FCA in this whole miserable affair just when he needs his CV to look at its shiny best.

Finally, it is worth noting that the whole incident has significantly raised awareness of liquidity risk. Funds all over the place are rushing to reassure us all that they aren’t breaching any rule and have no illiquidity problems. In most cases this will be true. But last week Mark Carney pointed out that $30trn of global assets are held in investment funds that promise daily liquidity to investors, despite investing in potentially illiquid underlying assets. “Under stress,” he said, “they may need to fire-sell assets, magnifying market adjustments and triggering further redemptions – a vicious feedback loop that can ultimately disrupt market functioning”.

We have said this before, but if you hold, say, emerging-market bonds, high-yielding bonds, or much in the way of unlisted assets (even commercial property) in open-ended funds, now is as good a time as any to think about whether you have chosen the correct structures (quick answer: probably not).

I could go on. There will be more consequences (the conversation about whether financial regulation should be less rules-based and more principles-based is back on, for example). But the point is not just that the Woodford debacle has consequences. It is that those consequences are rippling out all over the place. It’s just one fund. It’s just £3.7bn. But look at the ripples and you will understand why so many regulators and central bankers see fund managers as a systemic risk to the financial system.