Seismic drift in Woodford holdings extends beyond liquidity

“The reason we bought into Woodford in the first place was for downside protection,” says investment manager Jen Causton on why Architas was among a number of investors that followed the star manager from Invesco to his new shop.

Woodford Equity Income raised a record £1.6bn when it launched in June 2014, riding on a track record Neil Woodford had built up at Invesco Perpetual via holdings in large-cap defensive stocks with a small tail of unquoted and small-cap companies.

At launch, Woodford had pledged to deliver high single-digit annualised total returns for investors over a three- to five-year period. By the time the Woodford Equity Income Fund turned five in June 2019, it had been suspended for several weeks. If investors had been able to redeem their money, they’d be looking at a 4.65% loss since launch, compared with 34.17% gains in the FTSE All-Share, FE Analytics data shows.

Architas saw red flags in 2017, according to Causton. “The information ratio on the fund was starting to fall, as was the downside protection ratio.” The Axa-owned manager pulled its £34m stake in Woodford in November 2017 when the fund’s returns since launch were nearing 40% and were over 10 percentage points higher than the index.

Causton says it was Woodford’s less defensive style more so than his slide down the market-cap spectrum that concerned her, even though the latter is what ultimately led to the fund’s suspension. “In my experience, no UK equity fund manager we’ve held has shifted this much.”

The last time she met with him, in 2017, she was concerned about the size of his contrarian bets in the portfolio, particularly in banks and housebuilders.

Scottish Mortgage and Merian comparisons

Against charges of style drift, Woodford Investment Management has pointed out the manager had a track record of investing in small, unquoted companies while at Invesco.

But in September 2016, the shift down the market-cap spectrum was enough to warrant head of investment communications Mitchell Fraser-Jones to publish an update, titled Evolution not revolution. In it he stated: “We remain absent from the parts of the market that look most vulnerable to the economic headwinds and have focused the portfolio towards companies that can deliver sustainable growth in spite of them.

“Some of the larger-cap businesses that have exited the portfolio still look capable of delivering growth but other opportunities, some of them in smaller, earlier-stage businesses, have surpassed them in terms of attractiveness and conviction.”

The launch of Income Focus in March 2017 was when the shift in holdings in Equity Income started to concern Adrian Lowcock. The flagship Equity Income Fund had previously held companies associated with Woodford in its top 10, but that year he sold down his bet on pharmaceuticals in favour of domestics and housebuilders.

Lowcock also struggles to think of a manager who has shifted style as much as Woodford, pointing to Scottish Mortgage’s move into unquoteds as the closest analogy, albeit in an investment trust structure.

When Woodford Equity Income first launched, its rivals were his previous fund, Invesco Income, says Lowcock, plus mainstream UK equity income funds, such as Artemis Income and Threadneedle UK Equity Income – both of which have gained business from professional investors that have dropped Woodford Equity Income. The Merian UK smaller companies team or Marlborough smaller companies fund range might now be better alternatives, he says.

From big pharma to biotech

Astrazeneca, Glaxosmithkline and British American Tobacco led the top-10 holdings when Woodford Equity Income debuted in June 2014. Woodford had shunned sectors that were deemed vulnerable to a faltering economy, while tobacco and pharmaceuticals fit the bill due to strong balance sheets and attractive valuations, the company said at the time.

Woodford Equity Income at launch versus 2019

Source: FE Analytics

Five years later, none of those companies feature in the top 10. Instead, Burford Capital, Barratt Developments and Taylor Wimpey make up the top three. Benevolent AI, Theravance Biopharma and Oxford Nanopore all feature in the top-10 despite being unlisted.

In fact, the amount allocated to large caps in the Woodford Equity Income Fund at launch, 72.53%, is almost the same as the 71.49% that had been allocated to small and micro caps by April 2019, according to Morningstar data. Its allocation to large caps is currently just 3.16%.

Contrarian bet on Brexit doesn’t necessarily translate in holdings

Pre-Brexit, a bearish outlook for the UK economy was a persistent theme in Woodford’s investment thesis. For example, he poured cold water on the economic forecasts in the 2015 Budget, which predicted GDP growth of 2.3-2.4% over the five years to 2020, because it was too high compared with the 1.8% averaged over the previous five years.

A month ahead of the Brexit referendum, the Woodford team said the UK economy was so unbalanced that “something has to give”. House prices, a record-low savings ratio and an “all-time extreme” current account deficit of 5% of GDP were highlighted as the main concerns.

Woodford started to highlight the valuation opportunity in UK equities after Brexit in a Q&A feature that appeared on the Hargreaves Lansdown website on October 2016, whereby he stated he was mulling a US dollar hedge for the first time since 2008. However, it was not until the following summer he officially declared his contrarian bet on the UK economy, explaining his positions in housebuilders, banks and domestic cyclicals.

It is this investment outlook that Woodford uses to justify his current positioning.

However, one investment manager Portfolio Adviser spoke with questioned the way that stance was expressed in the top-10 holdings. Barratt Developments, Taylor Wimpey and Countryside Properties are the three holdings that could be described as cheap UK stocks, he says. At a stretch, Burford, a company that lends money to US lawyers, could also be included. But the rest are largely speculative biotech companies alongside doorstep lender Provident Financial.

In contrast, Astrazeneca and Glaxosmithkline are the top two holdings in Threadneedle UK Equity Income, while Artemis Income also holds Glaxosmithkline alongside Legal & General and Tesco, other stocks Woodford has held in the past. Evenlode Income, which Architas switched into after pulling funds from Equity Income, holds Reckitt Benckiser, a former Woodford stock sold on the basis of valuation.

Woodford compared to Equity Income rivals

Source: FE Analytics

Illiquid holdings less volatile

Before March 2017, Woodford’s allocation to what Morningstar categorises as ‘giant cap’ had ranges from 37.26% and 49.73%. In April 2017 it fell to 30.67% and then steadily reduced until it hit single digits in February 2018. There has been zero allocation to giant caps since August 2018.

It was during this shift out of giant caps that Woodford Equity Income was officially booted out of the Investment Association UK Equity Income sector, instead becoming an IA UK All Companies fund in March 2018.

Woodford’s shift down the market-cap spectrum is evident in the risk rating for the fund at Dynamic Planner, which upgraded him from an eight to a nine in late 2018.

However, using volatility as a basis for risk would have resulted in a rating of around five or six because of Woodford’s less liquid holdings, according to head of asset and risk modelling Abhimanyu Chatterjee.

“When one holds small cap or unquoted stocks, the problem is that because there is no trading volume, there is no volatility in the market. It gaps down. Second, if you have unquoted stocks, those are revalued once a year. It’s like private equity.”

Dynamic Planner increased the risk rating for the portfolio due to the unquoted holding increasing, the sector bias and the move out of liquid large-cap stocks.

“Over the past five to seven years, even though market volatility and income have been so low, there has been a higher incidence of equity income moving into small and mid-caps, but not to the extent we saw in Woodford,” says Chatterjee. Most equity income funds have a risk rating around seven or eight, he says.

In March this year, Woodford Income Focus was shifted from the IA Specialist sector to UK Equity Income.

That same month, Equity Income switched a batch of unquoted stocks in exchange for Woodford Patient Capital Trust stocks. “We believe we have a more clearly defined product set, making investor choices easier,” Woodford Investment Management said at the time, perhaps the closest it has come to acknowledging a potential style drift.

Woodford is a contrarian – not a stockpicker

Most fund managers have broad enough objectives for style drift not to be a de jure issue, says GBI2 managing director Graham Bentley. In the case of Woodford Equity Income, the objective is “to provide a level of income together with capital growth”. Its policy is to invest 70% of the portfolio in UK listed shares.

According to Bentley, the de facto style drift professional investors allude to is their perception of what Woodford was good at, namely a long bet of large-cap defensive stocks.

Not everyone accuses Woodford of style drift. “Woodford was always invested in small cap or unquoted companies at Invesco Perpetual,” says FE research manager Charles Younes. “Nothing has changed there. Woodford has made his track record not because of stockpicking but because of some strong contrarian bets, especially industry bets.

“During the financial crisis it was about avoiding banks. In 2010 and 2011, he started to buy a lot of pharmaceuticals. Not one or two but a lot of them at a time when many people were shying away from them. From that point of view, it’s in line with our expectations.”

The reason FE dropped Woodford Equity Income from its favourite funds list was the lack of resources focused on large-cap stockpicking.

Woodford has drawn on his track record of taking contrarian bets that have ultimately paid off in response to criticism of his underperformance. But Causton says his past contrarian bets have been defensive in nature, with Woodford shunning the technology and banking sectors when everyone else was risk-on.

His current contrarian bet is against UK bears. Causton says: “I was a little bit worried about style drift because I was thinking if everything goes wrong with Brexit then I’m not going to get my downside protection with this fund. I respect the fact fund managers need to hold their nerve and add to attractively valued areas in times of weakness, but it felt like a lot of bets were all pointing the same way.”