14 June 2019
The Neil Woodford case that has shaken the UK reminds investors of basic principles for managing their assets. The guy may be praised and blamed for many things but investors need to take some responsibility.
In a portfolio, asset allocation is said to yield up to 70% of returns. The remaining 30% is down to manager selection which is about execution risk. A bad manager can kill a portfolio return and leads to the failure of an investment objective which can result in a string of dissension, conflict and costly class actions.
The key takeaways of the Woodford fiasco are:
Concentrated exposure to a few investment managers is bad practice. Each asset class bucket should have more than one manager, especially due to style differences.
Allocating to a manager due to stellar past performance is misleading. Return chasing is the amateur’s first mistake. Falling prey to a star manager is their second one. The trouble is that in a bull market hardly anyone sees the issues until things go sour.
If one, however, believes in a star manager, one has to check how well this star manager can sustain his or her stardom. Research shows that a manager needs to be right 74% of the time to yield a higher return than buy-and-hold portfolio through market timing. Otherwise, they need to move into other, usually less liquid markets to beat standard market references.
Due diligence is more than reading a deck and having a couple of meetings with the manager. It involves checking the control chains; reading legal documents (prospectus, applicable regulations...) to assess if investors’ rights may be legally minimised; meeting all the teams; performing background checks; and reviewing the regulators’ websites for any red flags. Furthermore, due diligence must be thorough enough to ensure that the four-eyes principle is deployed at fund manager level, with proper checks and balances to monitor investment decisions.
Existing external research reports from the usual rating agencies do not suffice per se. Whilst they are important sources of information, they do not replace any due diligence or in-house managed investment universe. They are just one factor to input into the process.
Fund platforms are just product distributors. Their big lists are here to serve their needs for transactions by pandering to what misleads investors.
Word of mouth should not replace due diligence. It relies too heavily on past performance, personal enthusiasm and fails to recognise a manager’s life cycle. Managers tend to do well at the beginning of their venture, then they seek to stabilise performance to raise more and more assets. What happens when the markets shift against their speciality? Do they take more risk in order to gamble for resurrection?
Liquidity is key and is frequently overlooked. Liquidity tables that monitor a fund’s external liquidity (ability to pay investors) with its internal liquidity (delay required to turn 100% of the portfolio into cash in different market context) is an important part of diligent monitoring. This process needs to be rounded off with the investor’s own liquidity schedule: how easily can he or she sell all of his or her investments in different market environments while minimising the consequent losses.
No investor can exclusively rely on third parties intermediaries. This Woodford affair is yet another confirmation of the vital importance in having the right internal controls and due diligence processes in place that adhere to best practices. As such, there’s a role for investors to help each other out, to form a community and enable the dissemination of best practice.
Co-founder and CEO of Finlight