Advising clients and constructing portfolios is not a sentimental business, writes Kerry Nelson, as she addresses questions to be asked and lessons to be learnt from the Woodford Equity Income gating

‘The bigger they come, the harder they fall’ – the phrase could almost have been coined to describe the recent fortunes of Neil Woodford.

It is tough to think of a fund manager who has soared so high and – at least in terms of how his investment approach and standing are currently being appraised in many quarters – fallen so far, so quickly.

The gating of the Woodford Equity Income fund in June is arguably one of the most scrutinised episodes in the history of UK financial services and, for good measure, comes in the era of social media when it is almost impossible not to be aware of such things.

It should of course be borne in mind that, while performance has been far from ideal and – most worryingly – affected by a steady stream of redemptions, as I write this, Woodford Equity Income is still operational.

Clearly, though, as and when the ‘shutters’ are raised again, the fund manager and his team will face a new round of redemptions, the scale of which is hard to estimate. This period is likely to be accompanied by further intense and unforgiving media scrutiny at a deeply inconvenient time for those involved.

We also know that Woodford Investment Management has lost mandates and that the more concentrated Woodford Income Focus fund and the closed-ended Patient Capital Trust have come under some pressure too. This is, to say the least, a business with a lot of challenges.

And yet this is nothing like the sort of dreadful problems we have seen with, say, London Capital & Finance, Arch Cru, Key Data or countless ‘wild west’ unauthorised collective investment schemes. There has been poor performance but the majority of the money has not disappeared.

“Advising clients and constructing portfolios is not a sentimental business. Every searching question an adviser asks should be accompanied by further searching questions about their own assumptions.”

It is possible to imagine a situation where things calm down and Woodford is left with a smaller, more manageable investor base – or at least the ability to sell the business in less trying circumstances.

Having said all that, the Woodford situation presents an extraordinary challenge to the investment industry and advice sector – partly because the man himself has become part of the furniture of financial services. It is also because he has so often been shown to be on the right side of the investment argument (though that may have also contained the seeds of the problem now).

Many investors will remember – and be grateful for – Woodford’s resilience in the face of the tech bubble and indeed when he worked out that financials, and especially banks, were to be avoided. Still, while it is perfectly OK to have taken that past success into account, it should only be alongside a host of rigorous, forward-looking questions – including asking whether success of this nature, often involving big calls, is continually repeatable.

Advising clients and constructing portfolios is not a sentimental business. Every searching question an adviser asks should be accompanied by further searching questions about their own assumptions. Here, then – and purely in those interests of self-examination rather then anything approaching smugness – is an insight into our own thought process at Nexus, which saw us avoid the fund.

For one thing, we were concerned that this was not just a start-up business but a start-up business with huge pressures on the lead manager. Indeed, this is a worry we have had with much bigger asset management companies and their ‘star’ managers.

For another thing, we were concerned about the sheer scale of the fund’s initial asset-gathering success, which constituted a different investment management challenge – growing a fund over many years is very different from directing billions of assets into the market over a much shorter time period.

We also worried that the fund – where it was looking at smaller, less liquid assets – had as a major investor a very different relationship with those smaller companies. And this was borne out by the firm having to honour pledges of some very big investments in these firms in recent months – and at just the wrong time.

Furthermore, we were concerned about the extensive overlap between the various funds’ holdings, given the already close relationship between Woodford and some of the stocks he was investing in. We do understand the high-conviction argument but, in this case, it did arguably concentrate the business risk and associate it with some very specific investment views.

More broadly, we simply did not like the illiquidity – and, in truth, we have been surprised by the fact that our small investment committee could see this, yet larger players with much larger teams and research resources apparently could not.

More recently, it was difficult not to be aware of some very large investors appearing to lose faith while, at the other end of the scale, much smaller yet experienced investors were asking questions about liquidity and the fund’s profile on message boards and even the fund’s own blog.

We would argue the implications of the fund’s 2018 ejection from the Investment Association’s UK Equity Income sector were also underestimated – partly because the same fate had befallen other fund managers. Our own view, however, was that it meant the fund was not doing what a lot of investors would have expected from a mainstream equity income fund.

Finally and importantly, we concluded the fund did not offer a solution to any of our clients’ problems – that is to say, it did not match the risk and related performance requirements in a way we could not achieve with other funds with fewer question marks hanging over them.

We have thought long and hard about this and have notes to look back upon, so we are confident we are not writing with the benefit of hindsight. Indeed, for some time now, we have been quite open about these views in conversations with our peers and with the media.

That is not to say there have been no surprises – such as the revelation the St James’s Place mandate had demanded the exclusion of the most illiquid stocks. In addition, if you read the letter from Financial Conduct Authority chief executive Andrew Bailey to Treasury select committee chair Nicky Morgan, you will find a detailed account of how the authorised corporate director managed liquidity concerns and maintained mostly successful communications with the regulator.

And, in the spirit of continually looking to improve our business, we will now be adjusting our thinking as it relates to sentiment towards large funds – especially given the role of big execution-only fund supermarkets, both in promoting direct investment and investment through multi-manager products.

The episode has brought home very clearly that it is not only smaller investors who can steadily lose faith but also very large ones too – after all, it was the Kent local authority pension fund’s request to withdraw that proved the final straw. As such, we will be giving the investor base of any fund even more thought in future.

Overdramatic coverage

Turning to the broader impact on the investment market, we do worry the overdramatic coverage of Woodford Investment Management’s travails in some quarters of the press could mean the idea of fund investing could take a knock. Given the appalling record of people risking all their savings in non-regulated products, this would be a great shame.

We also have concerns about the reputation of advisers. There have been dark mutterings about big portions of client portfolios being allocated to Woodford Equity Income – up to a quarter in some instances. If true, that could be very bad news for the profession – although we hope most adviser and indeed discretionary fund manager portfolios either moved away from the fund or have a relatively small exposure.

There is also an argument the received wisdom – that it is usually better not to cut your losses, and stick with a process you believe in – needs to be tested because, in certain ways, Woodford’s process seems to have drifted and there were plenty of signals this could be happening.

Last but by no means least, we are examining how we communicate with clients on the subject of active fund management. We continue to offer both active and passive fund management in our portfolios, believing this remains the best way to deliver for clients – provided it is accompanied by rigorous research.

The question does need to be asked, however – did too many advisers and distributors see Neil Woodford and his company as an appealing story with name recognition to discuss with clients? Ultimately, this episode may prove the last hurrah for the star fund manager culture – and that is no bad thing for the advice sector and the investment industry as a whole.

Kerry Nelson is managing director at Nexus Independent Financial Advisers

This article first appeared in the August issue of Professional Adviser’s sister title Multi-Asset Review, which is now out.