The widely held bemusement is the focus in this article because as an analyst who has spent most of my admittedly short career focused on alternative investments (which are typically less liquid and therefore at higher risk of trading suspensions) I was amazed at the surprise about Woodford’s lack of liquidity.
Initially I said to myself: surely a daily-dealing UK equity fund with a 10% level of unquoted stocks would have no investors going near it? There are fund managers that investors avoid with much smaller funds than Woodford’s, and whose portfolios are entirely invested into exchange-traded stocks, let alone in un-listed companies. Alternatively, for those who invested in the fund, I presumed it would be sized as a satellite and risky position but not a core holding.
However, on reflection this thought is somewhat naïve and arrogant, and maybe the problems weren’t so obvious. The reason for this is that some of the common excuses for illiquidity in a portfolio have become almost universally accepted; three common ones are:
- The illiquid part of the portfolio is a small percentage and we can meet redemptions if we sell the liquid parts of the portfolio.
- It doesn’t significantly alter the fund’s expected risk/return characteristics, so it can still be considered a core holding.
- We have long-standing and loyal investors who have proven to stick with us even during underperformance, so we don’t worry about redemptions affecting the strategy.
Taken at face value these statements seem to be reasonable, especially considering that normally there is no liquidity squeeze in markets and people are not rushing to withdraw money from funds all at once. However, the key problem is they are all cross-sectional statements: they may be true of the fund now, but they ignore the potential for drift over time as the size of the fund changes.
Most of the surprise stems from the first issue. In the case of Woodford, and in the past other funds such as the GAM Absolute Return Bond Fund, the positions that have caused their problems all initially started as a very small percentage of the fund. The issue gradually inflated due to regular underperformance of the whole portfolio and the ensuing withdrawals from the fund having been small and consistent.
Consequently, the liquid positions were sold to meet the redemptions, but without one big liquidity event that is harder to hide from scrutiny. If you consider the AUM graph for the Woodford Equity Income Fund below, there are few months where outflows above 5% of the fund’s total value (a conservative threshold to cause an investigation). For investors who don’t monitor their funds on a regular basis, it could very easily have been missed. Furthermore, they may think that if redemptions are small then they shouldn’t have an impact on the fund’s ability to trade and therefore performance.
The result is that the initial illiquid positions have not been sold down pro-rata for the fund and now form a higher relative portion of the portfolio, increasing liquidity risk for remaining investors. There are two reasons for not selling the illiquid holdings:
- Should you sell a sizable holding in an un-listed or thinly traded stock (perhaps listed on the Guernsey stock exchange) then it will move the market price down and lock in a loss.
- The rest of your holding will be marked down too. This leads to further poor performance, causing more investors to worry and ask for redemptions.
This turns into a vicious cycle that ultimately leads to the situation we have now: a fund gated so that investors are not able to access their funds. So, you can see why a fund manager might be unable or reluctant to sell their illiquid holdings.
The lesson to take from this debacle is: whenever there is uncertainty surrounding liquidity, even of a small investment within a portfolio, it is extremely important to monitor AUM flows on a regular basis, placing as much emphasis on regular outflows as you would on sharp changes, and to understand different scenarios that might occur in extreme events that could change your view on the liquidity of the fund and therefore its positioning in your portfolio.
Certainly, there is an argument to be made that for most investors, any fund with un-listed equity holdings in the portfolio should not be a core position. This is a key area where action needs to come from the regulator, particularly as there are increasing numbers of alternative strategies where less-liquid positions are fitted into retail orientated, UCITS structures.
Louis Tambe is a fund analyst at FE