How are the mighty fallen

Neil Woodford: why investing in ‘star manager’ funds can be dangerous

Spare a thought for anyone invested in the Woodford Equity Income Fund, managed by Neil Woodford. The fund was suspended this week, following an unexpectedly high level of clients taking their money away from the fund. When Kent County Council wanted to withdraw the £263 million they had invested, Mr Woodford suspended trading in the fund, to protect all of the investors in the fund, which means that no-one can get their money out.

The Woodford Fund invests in some unquoted companies, which cannot be easily sold, and does so in a much a higher proportion than most other funds. When investors lose confidence and start to sell, these illiquid investments can’t be sold quickly or easily, and therefore to pay out the redemptions, mainstream, liquid, lower risk companies have to be sold. This means that the proportion of risky, illiquid stocks rises – it was up to 18% of the fund at one point.

There is absolutely no doubt that Neil Woodford has in the past delivered returns to investors in excess of what they could have obtained from simply investing in the market.

The question is, At what cost?

It is an immutable law of the universe that risk and reward are related, at least when it comes to investments. Attempting to achieve higher returns inevitably involves taking extra risk; it follows that taking extra risk should, in itself, lead to a higher return – the technical term for this extra return is called beta (β).

The difficult bit is achieving returns that are better than are due to investors simply for turning up and taking risk. The technical name for this excess return is alpha (α) and the evidence is that on average, over time, and after costs, α is very elusive.

The question is, has Mr Woodford consistently generated excess risk-adjusted return, alpha, through skill, or was there an element of luck?

If we could be reasonably sure that a particular investment manager’s outperformance is due to skill rather than luck it would make sense to use that manager, however this is also incredibly difficult to recognise. There is a mathematical reason for this; it’s all to do with statistics.

Suppose we have a fund that has experienced annual returns of 5%, and volatility of 20%. How long do you think it will take until there are enough data points to give any confidence that the results are due to skill rather than luck? A year? Two? Five?

How about 65 years!

Nobody, but nobody, has a track record that long, which is why it is very unwise to use a manager’s track record to judge whether he will be any good in the future.

Oh, and in case you are concerned about it, none of our client portfolios are invested in any Neil Woodford fund (or indeed any actively managed fund.)

As ever, please get in touch with myself or one of the brilliant Navigator team if you have questions or concerns about this or any other financial planning matter.

David Crozier CFP