Woodford & the Difficulty of Picking Stock-Pickers
The big story dominating the financial press over the past 6 months has been the fate of star-manager Neil Woodford and his UK Equity Income fund. It became headline news early in the summer when the fund suspended trading, leaving Investors unable to get their money back. The suspension itself triggered a bank-run style rush of investors demanding their money, which ultimately brought the fund and Woodford Investment Management down.
What Happened and Why?
In short, the fund performed poorly over a period of 3 years, having initially done well. This led to investors withdrawing their money; assets collapsed from c.£10bn to around £3.5bn prior to suspension. This is not exactly unusual behaviour, investors have always chased performance, moving in and of out of funds based on short-term returns.
Why this triggered the rapid downfall of Woodford is that the fund invested in a lot of small companies, whose shares were illiquid and difficult to sell. The fund spent months selling its larger, liquid company shares to pay exiting investors, leaving the fund holding an ever-increasing proportion of these small, illiquid stocks. In order to protect the remaining investors (and not breach its own investment rules), the fund suspended trading to buy time to sell some illiquid stocks. There wasn’t any real option but to do this, however it ultimately triggered the demise of the fund and Woodford.
Conventional Wisdom, the Star Manager & Chasing Performance
The conventional wisdom of investing has been to find investment managers to outperform markets by identifying ‘mispriced’ securities and cleverly timing moves in and out of markets. Managers are hired and fired based on their performance. ‘Star managers’ with the best records collect accolades and investors’ assets. For years Woodford was one of the biggest and brightest names around.
There are however several major problems with this conventional approach. Most importantly, outperformance doesn’t persist – shown by numerous studies dating back to the early 1990’s. Very few managers outperform over the long-term and even those who do, will usually go through sustained periods of underperformance.
A study by Vanguard[1] of UK equity funds over 15 years to the end of 2016 showed that of the 513 funds available at the start of the period;
Only 34% survived 15 years
Only 9% outperformed
Only 4% outperformed without incurring 3 consecutive years of underperformance
Investors chase performance; investing in managers that have performed well. As soon as returns disappoint, they move onto the next fund du jour. Consequently, most investors typically miss out on the best periods of advertised returns.
This is evidenced annually in the US by a company called Dalbar[2]. They compare the return investors receive on each $ invested, compared to headline fund returns. Almost every year, investors significantly underperform their funds – mainly due to chasing performance.
Crucially, there is no reliable way of picking which funds/managers will outperform in the future. Certainly, recent past performance is of no use. Furthermore, fund ratings and provider best-buy-lists have no predictive power – the later largely being driven commercial relationships, as was laid bear with the Woodford fund and a well-known, large investment platform.
The Solution: A Systematic Investment Process
You cannot control whether the investment manager you selected will out or underperform. You cannot control whether the fund you picked will even be around in 5 years’ time.
Instead, focus on a.) what you can control and b.) what matters (as shown by theory and evidence); gain efficient exposure to an appropriate asset allocation and stay disciplined throughout market conditions. This is an over-simplification, but in essence is what most investors need to do. If you need assistance, there are systematic, evidence-based advisors like Collingbourne who can help you.
It’s important to remember what it is your investments are actually for. The likelihood is whether or not you outperform the market, will not be a deciding factor in making your financial plans work or not. The likelihood is that picking the next performing fund or star manager is a risk, effort and stress that you don’t actually need to take.
[1] Sources: Vanguard calculations, using data from Morningstar, Inc. Notes: Data is from Jan 1, 2002 through Dec 31, 2016. Our analysis was based on expenses and fund returns for active equity funds available to U.K. investors at the start of 2002. The oldest single share class was used to represent a fund when multiple share classes existed. Each fund’s performance was compared with that of its prospectus benchmark. Funds that were merged or liquidated were considered underperformers for the purposes of this analysis.
The following fund categories were included: US Large-Cap Blend Equity, UK Small-Cap Equity, US Large-Cap Growth Equity, Europe Large-Cap Blend, US Large-Cap Value Equity, Europe Small-Cap Equity, Global Large-Cap Blend Equity, Global Flex-Cap Equity, Global Large-Cap, Growth Equity, UK Large-Cap Value Equity, UK Flex-Cap Equity, Europe Large-Cap Value Equity, Global Emerging Markets Equity, Global Large-Cap Value Equity, Global Small-Cap Equity, EMEA Equity, US Flex-Cap Equity, Emerging Europe Equity, Europe Flex-Cap Equity, Eurozone Large-Cap Equity, Europe Mid-Cap Equity, US Small-Cap Equity, US Mid-Cap Equity, Europe Large-Cap Growth Equity, Eurozone Mid-Cap Equity, UK Large-Cap Growth Equity, Eurozone Small-Cap Equity
[2] DALBAR Inc. QAIB (Quantitative Analysis of Investor Behavior)
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