Sunday 7 July 2019

Neil Woodford

Neil Woodford was up until recently the man who made middle England rich. A star money manager that at one time could do no wrong. Of late his fortunes have changed. Since 2017 his fund has hit problem after problem with it culminating in the suspension of trading in one of the main funds he manages. Theres a couple of topics I would like to discuss. We first need to look back at his past to understand why he had such an esteemed reputation and if it was warranted. Then I would like to cover alpha funds and the active money manger myth, whereby regular people can pick active funds to beat the market over the long run, when study after study has conclusively proved that the vast majority of funds do not beat the market. Finally I explore what should you do if you are invested in his fund that has been suspended (not a lot you can do at the moment as its suspended and will probably be suspended for months). 

For an excellent summary of what happened and also some thoughts on how fund industry best buys lists are hard to trust watch this video.

Neil Woodford had a long track record of beating the market, his equivalent benchmark being the FTSE All Share Index. As can can be seen in the below graphic he has appeared to have found the secret formula and had the midas touch to pick the right stocks. Consequently when he left Invesco many retail investors followed him and he set records with the amount of inflows of money into his new fund.

For the first couple of years it appeared to be business as usual, he was once again beating the market.

However as the red line of his fund shows above, gravity began to set in. A series of bad investments, money outflows and negative news meant the fund began to loose any prior gains it made, in fact over 5 years when stocks have been in a bull market, investors are down on their money in his fund and it is gated probably for months. So what went wrong and can he bring it back?

Analysis of Prior record

While it is too premature to say Neil Woodford is finished, I do however personally believe when analysis is applied that Neil Woodfords prior record as a star manager is somewhat overblown. The top graph of £10,000 can look impressive, however when examining the details it is less impressive. Someone broke down the gains Woodford made during the start of the new century and grouped the relative performance into chucks around events (see below). What they found is that Woodford only broadly beat the market during two spells - the dot com bubble and the financial crisis. All other periods it was pretty much on parity with the market (prior 2000 we know he pretty much tracked the market). Many other funds did well during the dot com bubble as dozens of dozens of investors were talking about the mania at the time. And the financial crisis of 08-09 when Woodford avoided the banks was hardly genius. Back when I had little financial knowledge I could tell back in 2006-2007 that things were not right in the housing market (its one of the reasons I started blogging). 

The following quote is taken from this article -

Investors who bought funds run by Mr Woodford at any point after the 2003 bear market and still hold funds he runs today will have underperformed the FTSE All-Share index by anywhere between 25 and 85 percentage points.
This statement really does put it into perspective (in facts its actually got worse as this is only to March this year well before the gating and more losses for the fund). Neil Woodfords returns look spectacular when the £10,000 graph contains the compounding effect however in reality you have only gained if you bought in before the dot com boom (maybe you could have traded the fund at the right times but for retail investors its a case of buy and hold for long periods of time). The £10,000 compounded over time graph makes Neil Woodford appear to be a genius when in reality it was one short period where he made his gains (which was nothing unusual at the time - lots of active fund managers had the same out performance at the time, this is why there was an explosion of hedge funds around 2000 as many also avoided the Dot Com Bubble and became subsequently popular). 

While at Invesco its also hard to tell if the stocks and direction Neil Woodford took was his own original ideas. This is usually the case in many companies whereby low key analysts/programmers/engineers are the ones that come up with the truly original thinking but there is some figurehead/frontperson who takes the praise in the media spotlight. Invesco at the time may have had analysts at the time who were warning about tech stocks, the banks etc with conversations taking place around the office, recommending sectors to invest in and value companies. We will never know but it is clear something went wrong when he was took out of this environment.

One final point regarding his track record was the length in which he managed to sustain it meant that in all probability he would under perform at some point. The statistics of someone being able to beat the market over decades is phenomenally slim (for example the most famous and wealthy stock market picker Warren Buffett no longer beats the market). Always be weary of people who outperform the market for many years as the chances are conditions will change and so will their luck.

Will he be able to Recover?

No one can say but we can analyse the odds and they don't look good. Woodfords fund is well down compared with the FTSE All Share. In order to get back he has to make significant returns in the next 5-10 years. He has never at any point in his history been this far behind that would be my first concern. My next worry is the strategy he has pursued in recent times. He ran into trouble as he invested in many smaller illiquid companies/startups. This was at odds with what he did at Invesco which was to buy larger companies that paid good dividends. Now after the recent troubles he has stated he plans to sell these smaller illiquid companies and move back into FTSE-350 companies. To me this just makes him appear that he made a grave mistake, didn't really know what he was doing and should have stuck with what worked originally. It would not inspire confidence if I had money in his funds. 

In the past during the Dot Com boom when he avoided Tech stocks he said they were in a bubble and that was why he was avoiding them. He got a lot of stick for taking those actions but at least he had a story, likewise avoiding banks because of the sub prime/overinflated housing market. His story this time is weak by comparison. He still states that the companies he bought are massively undervalued and that it is only a matter of time when their value is realised, only this time he openly admits he does not know what will cause this realisation. There is no bubble in a certain sector, no housing bubble. Thats because generally economic conditions are actually quite good; goldilocks conditions. Inflation is low, housing is not in an unsustainable bubble as interest rates are very low, stock markets are not massively over where they were 20 years ago (in the FTSE-100 case at around the same level), unemployment is at multi decade lows, company earnings are good - there is nothing on the horizon that suggests there will be something that will reset to allow his stocks to rise.

Woodford is now also in a bind where he has had to sell companies maybe for prices that are still not favourable even with the gating. This also has entailed extra transaction costs as he sells a lot of existing stocks and buys back into larger companies.

Stick or Leave

Many independent reports have been published stating active fund management never works in the long run. The evidence in support of passive funds is quite clearly overwhelming. Even if you were sceptical of such reports consider that it is actually a mathematical impossibility for active funds as an aggregate to win over passive funds in the long run. If for example the market gives long term returns of 7% then a passive fund will give 7%, with low expenses of around 0.10%. This is guaranteed as they aim to just track the market. Active funds all aggregated together can only make the market return in the long run. Its impossible for them in aggregate to outperform the market as its a zero sum game - for every winning fund there must be a loosing fund in order to match the markets return that they are invested in. However Active Funds can only loose in the long run due to their fee's, those fund managers with their teams of analysts and their expensive tastes cost money, lots of money. With active management this can be anywhere between 0.75% - 2% (and sometimes as in Woodfords case in more expensive platforms such as Hargreaves Lansdown). 

Therefore being invested in active funds means that beating the general market will have more to do with luck of picking the right horse then down to skill of picking the right fund - the odds are always in favour of the house - or in this case the broad market. Over time it has become harder and harder for fund managers to beat the market, there are many reasons why this is. One such reason was in the past many retail investors were invested in poorly managed active funds or tried to stock pick like the professionals. This created many opportunities for the professional fund managers to exploit these mis-pricings and gain an edge. Recently more and more retail investors are buying passive trackers as the cats out the bag that its the best way. This means people in the active fund space are more professional and consequently the market has become more and more efficient making it harder and harder to gain that edge. Household names like Warren Buffett no longer beat the market - a passive S&P 500 tracker now beats him. George Soros who made great returns 40-50 years ago states that back then he had a very amateur operation compared with now but was still able to smash the indexes. Now he has admitted it has got harder and harder and he would have never made the returns now that he made back then. 

While more and more money flows out of active and into passive why do people still believe in active? Firstly there are many who are not aware of all the above. Couple that you have a financial industry that have a vested interest in trying to maintain the alpha cult. If they tell people its complicated, you need our advice for a fee then this is all beneficial for them as it justifies them getting a cut of your money. Secondly many people psychologically can not deal with just getting an "average" return. We all believe we are better than the average, we are smarter than the herd, therefore we want to pick that winner to get us better than average returns. Finally some people get greedy. The graph at the top shows how much more money you can have if you pick right so just like playing the lottery people believe they can hit that jackpot.

If two of the most successful investors of all time admit they are beaten by a simple market tracker than how does someone with little of no financial expertise pick a "star" fund manager? The only way someone does that is by analysing a funds past track record. Usually such a fund has done well for a 5-10 year spell, the financial media hypes the fund, people jump into the fund, economic conditions change and finally the fund usually underperforms at some point. This pattern repeats again and again and there will be others in the future. A popular fund at the moment is Fundsmith, headed by Terry Smith. For the past decade it has clearly outperformed the market and built up a large following. It has been hyped in the media with more and more people drawn to it. If you analyse the makeup of the fund it is highly concentrated into around 30-40 global companies. The story from Terry Smith is similar, he states they buy quality stocks and avoid all the other bad companies in the global index. If it was that simple then everyone would be doing it however it never is. At some point conditions will change, the stocks Fundsmith holds will become out of favour and the returns will lag the index, eventually undoing all the prior performance. Fund managers probably don't care. They churn and burn consumers and get their fee upfront before the rot sets in and have more than enough money to retire on.

So if you own a fund with Neil Woodford should you sell or hold? In the short term due to the gating there is no other option but to hold. The fund has now probably become oversold as its value has plummeted so in the short term you could hold on as it bounces back a bit, but in the long term? Unlike before, there is no track record of Neil Woodford recovering from his current position, now it is a matter of faith if investors decide to stick it out with him. I'm more than happy to review this post in another 5-10 years and eat humble pie if he makes the comeback of a lifetime and turns it around, after all this has just been my opinion on my blog. However I do know for a fact that over the long run Neil Woodford like the majority of his peers are destined to under perform the market. So its not really a question of if you should stick it out with Neil Woodford, its a case of should you stick it out with active fund managers over passive market trackers. If you pick the active side then the odds are quite simply stacked against you. Passive in the vast majority of cases will always win out. It also means you can buy and hold for life with nothing to do or worry about. They call it passive income for a reason.