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Anarchy in the U.K.

Active management's dangerous infatuation with private-placement securities.

Falling Star No, I don't mean Brexit, although that certainly qualifies. I refer instead to the astonishing collapse of Neil Woodford's organization.

Britain's best known stock-fund manager (some would claim Anthony Bolton but Morningstar's Holly Black dissents, and that's good enough for me) left Invesco in 2014 to form his own company. Thanks to his previous fund's outstanding 26-year record, Woodford raised almost GBP 2 billion during this first two weeks at the helm. That amount would eventually become GBP 10 billion.

And an unfortunate GBP 10 billion it was. Woodford’s new funds invested heavily in privately held companies that were difficult to trade. If the funds performed badly, thereby sparking redemptions, Woodford would be forced to sell his liquid positions, which would make his funds that much more dependent on their private placements. Such news would spook shareholders into increasing their redemption requests. It would be the modern equivalent of a run on the bank.

Which is exactly what happened. By spring 2019, a series of unfortunate events had put Woodford's funds at the bottom of the performance charts, and the buzzards were circling. In response, Woodford closed the gates this June to his flagship fund, Equity Income. No further redemptions were permitted. Besides fearing the return on their capital, shareholders had a new concern: the return of that capital.

Their Fears Were Justified Under such circumstances, the "experts" almost always counsel patience. Hold tight, let the crisis abate, don't panic. Time will heal all wounds. A missive in this spirit landed in my email box on July 31, courtesy of a financial-services consultant called TORI Global. It read:

“Neil Woodford continues to be a fundamentally good stock picker unwittingly caught in a perfect storm. The lack of sympathy is entirely understandable, but his record and his investment process are both still to be admired. Bad luck, inept management in some of his holdings and the gradual building, and lack of addressing, of negative City sentiment have combined to drive this situation.”

The recommendation is not explicit--evading commitment being among an expert’s most important abilities--but the statement suggests forbearance. Woodford “continues” to be skilled, using an investment process that is “still” commendable. Thus, his funds are best understood by evaluating his entire, 30-year investment history, rather than by their admittedly distressing recent news.

The same consultant’s Oct. 15 message read rather differently:

"This is a very sad day for the reputation of investment management. Our industry depends on trust and faith in good governance and there can be no doubt that the public's feelings in both of these areas will be shaken. I am always surprised how slowly action is taken in cases like this …"

The italics are mine. Irony, thy name is TORI Global.

On Oct. 15, to continue the analogy, the bank foreclosed. The administrator of Woodford’s funds fired him from his position as portfolio manager (thereby showing more independence than I would expect of a U.S. mutual fund board), and announced that the funds will unwind their positions. Eventually, they will return what remains of their original capital. That won’t be an entirely happy event. Equity Income, for example, has dropped 42% of its value over the trailing three years.

Addition by Subtraction Two lessons seem clear from the Woodford saga:

1) Mutual funds shouldn’t hold non-public securities.

That they are permitted to do so in both the United Kingdom and the United States is a triumph of hope over experience. The hope is that, by expanding their investment universes, mutual funds can improve their returns. Having greater opportunities should lead to higher future profits--particularly when, as with private equities, the new asset class offers higher expected returns.

Not so much. Indeed, shows experience, not at all. One problem is that those expected returns may in fact be illusions. Recently, several U.S. stock funds have lost money in so-called "unicorns"--startup companies that are worth more than $1 billion. Some argue that such disappointments are to be expected, because when private firms reach such high valuations, they no longer are attractively priced. They won't match private equity's historic returns.

Even if mutual fund managers were skilled at buying private securities, though, their gains would not be worth the reputational cost. To my knowledge, Woodford’s offerings are largest funds to enter the illiquid-assets death spiral, but they certainly have not been the only such victims. The U.S. has its own examples. In addition, several U.S. funds have been censured for mispricing their private placements--a problem that does not occur with publicly traded equities.

Allowing funds that price daily to hold investments that do not is foolish. The proper mutual fund limit for such securities is nothing.

An Irreversible Trend 2) Index funds will conquer the U.K., too.

In the U.S., the turning point for active management was 2008. Understandably, actively run equity funds had trouble beating the fully invested indexes during the mid-decade bull market, but, promised their sponsors, their relative fortunes would turn when the bear market arrived. Any boat can ride a tailwind, but only skilled hands can steer into a headwind.

Then came the global financial crisis, and index equity funds fared no worse than their active competitors. Their proposition failed. The same has now occurred in the U.K., where the mutual fund industry had conceded that, yes, the average actively managed fund wasn’t impressive, but safety could be found with the truly elite--the handful of managers who had thrived not for merely years, but for decades. Chief among them was Woodford.

Once bitten, twice shy. Moving forward, I expect that a great many U.K. investors will emulate their American cousins. Woodford demonstrated that no actively managed fund, no matter what its pedigree, is truly safe. Better then to seek tracker funds (as the locals call them). They might fail absolutely, should the financial markets crash, but they will never become relative embarrassments.

Although I have framed this column as a two-country discussion, it applies globally. Some countries have tighter restrictions on holding private securities, while others have powerful cultural preferences for active management. Thus, the lesson is not universal. But as a general rule, active management struggles with controlling the problem of manager risk--a risk that is heightened, rather than reduced, by active management’s fondness for investing outside of the public markets.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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