Conflicts of interest in fund manager market exposed by Woodford
Celebrated investor’s decision to run an open-ended fund suited everyone except investors
In the days since Neil Woodford shuttered his Equity Income Fund to redemptions, many have questioned why the celebrated asset manager ever structured this one-time £10bn monster as an open-ended investment scheme.
The main perceived benefit of such funds is the ATM-like promise of instant liquidity. Which means the manager must always be prepared to liquidate to satisfy redeeming investors. Yet Mr Woodford’s prized forte was long-term investing, not benchmark-hugging. Not only had he put the fund into some illiquid unquoted investments, thinking they would do better in the long term, Mr Woodford had even gone so far as to stop paying his staff short-term incentives. He preferred to put them on straight salaries to keep them focused on the longer goal.
Mixing long-term strategies with ATM promises created a vulnerability that might have been avoided had he established a closed-end fund that was not at risk of opportunistic liquidation. Indeed, the open-ended structure contributed to the pickle that Mr Woodford and his investors now find themselves in.
So why do it? Those seeking an answer could do worse than follow the investor’s dollar. Independent financial advisers such as Hargreaves Lansdown and St James’s Place are the key gatekeepers for retail investors. For the IFAs, there’s a financial advantage to peddling open-ended structures. While these may not be as lucrative, fee-wise, as more specialist asset classes such as private equity, they are marketable to the widest retail audience.
And that’s not their only merit. Open-ended funds are also easily scalable, subject only to demand or the fund manager’s discretion. In this they differ from closed-end schemes, such as investment trusts, which take a fixed chunk of money. IFAs can put such products on their platform’s so-called “best buy” lists for steady sale, negotiating a discount with the manager and inserting their own fees gently into the compensation equation.
Marketing Mr Woodford’s fund was lucrative for Hargreaves Lansdown. When the manager obligingly cut his fees they were able to shoehorn in their own charge of 0.45 per cent per annum on top. The firm carried on flogging the fund long after its decline.
As to Mr Woodford himself, well the answer perhaps lies in the symbiotic relationship between the manager and these marketing machines. As a star manager setting up on his own, he had a strong incentive to play by the rules set by the biggest retail gatekeepers.
Whatever the fund management industry claims, the overwhelming desire remains to gather assets, assets and more assets. That’s because success at the top for a manager may be fleeting. While you are still in vogue, there is a visceral wish to cash up when you can.
Surveying this patchwork of poor incentives, it is hard to escape the irony. By piling on too many funds too quickly, Mr Woodford actually set himself up to fail. He bid up his chosen pool of stocks with the wall of cash he had assembled. That made their subsequent underperformance more certain. As for the unlisted stocks he bought, they seem to have been a way of diversifying away from overpriced holdings — albeit one that badly misfired.
The one party uncatered for in all this, of course, is the end investor. While the intermediaries are all acting rationally in their own interests, its outcome — and that of society — is distinctly third rate. Consider, for instance, where the costs of Mr Woodford’s venture end up falling. As at the end of March, so before the final swoon, the Equity Income Fund’s overall returns — based on a notional 1 per cent take and using a money-weighted calculation — split 91 per cent to the managers and only 9 per cent to the investors, from Financial Times calculations and using Morningstar data. Things have deteriorated since then. Even at its peak at the end of 2016, the manager’s cumulative take was 10 per cent of returns.
These numbers are simply not sustainable, and point to a yawning gap between the interests of intermediaries and end investors — one made easily exploitable by the information asymmetry between Joe Public and a sophisticated fund management machine.
They are also reflected in the high aggregate costs of fund management services. In several studies it has been shown that these are the same today as they were 70 years ago. Incredibly, the finance industry that funded the economy in the 1950s was as efficient as its counterpart today.
Perhaps investors in Mr Woodford’s fund should have listened to Paul Volcker, who once found himself sitting next to “one of the inventors of financial engineering” and asked what it did for the economy. It did nothing, the US central banker was told, but it “moved around the rents in the financial system and besides that was a lot of intellectual fun”. This is not a game for which savers should be paying.