Seeing the Woodford from the Trees
Background Image Credit - Max Van Den Oetela - Unsplash
"You have to have a sufficiently strong arrogant gene to back your judgement, back your conviction. If you didn't, you would end up with a portfolio that looks very much like the index. But, equally, you must have the humility to accept that you will get things wrong." - Neil Woodford
As many investors are still left reeling from the depressing fall from grace of one of the investment industry's once brightest stars. We’re left to reflect on what this saga can tell us about the difficulties of differentiating from luck or skill and maintaining performance in excess of the general market return over time.
We as humans are hardwired to follow a story. Much of the fund management industry is set up to cater to this. Generally, conviction is seen as a good thing, we like it as it reflects a level of certainty in a hugely uncertain world and being resolute in the face of a shaky market. The problem is that 'conviction' can also make us blind to new information and 'intuition' can lead us astray. In the seminal book 'Thinking Fast and Slow''s Daniel Kahneman writes:
"Intuition is nothing more and nothing less than recognition."
From the spark to the flame
Neil Woodford was a very successful fund manager. From 1993 to 2014 the fund he managed the Invesco Perpetual High Income Fund with an average return of 6.3% compared to UK equities (FTSE All Share) which delivered 3.6% annually. Woodford did make some genuinely good active calls, he managed to generally avoid the tech bust-up in the latter part of the 1990s as well as the majority of bank stocks in the run-up to The Great Financial Crises.
You have to say being a fund manager is an incredibly tough gig. You are up against a market that is generally efficient which means it has already priced in what it considers a fair reflection of value. You are being paid to outperform but every time you put on a position you run the risk of the costs eating into your investor’s return. If you stand still, as your costs are often higher you'll lose through inertia. The consensus is already built into the price so you have to not only be right but you also have to make sure your bets return enough to recoup the often higher fees.
Problems for Woodford started occurring when he started moving to smaller companies. A change intact from his previous successes. In hindsight, this would prove to be a step away from his circle of competency. Fund flows driven by 'best-buy' lists and the natural allure of star fund managers drove in capital from various sources.
Unfortunately, the performance never lived up to the promises of his earlier career and after a consistently poor performance. A cataclysmic mix of well-publicised profit warnings from some of the underlying holdings caused investor confidence to wane. This led to many investors trying to get out of securities that were in fact far more illiquid than many had believed. Then the eventual suspension of Woodford's fund in June 2019 trapped many investors inside and liquidation followed.
It has not been a proud moment for industry or regulators alike.
How to spot a forest fire?
Style Drift
Check the fund factsheet, what was the fund designed to do. Style drift is when the manager starts to deviate from the initial purpose or style of the fund. There is analysis you can do involving similar holdings but as holdings can often be opaque at best, it's unlikely to be easy. Also, what is an unacceptable change in style and what is the manager just following their 'conviction' in order to time things correctly? If you have an active manager you are paying them to not follow the crowd at the end of the day. This will be difficult to spot and identify as ironically it could be argued you want 'active share' for using an active manager which is how much they differentiate in holdings from a given benchmark. The problem really lies in where is the 'line' between the conviction you are paying for and going off the rails. The truth, the answer is in the performance, not the process. However, therein lies the problem.
Past performance is no guide
It is probably the most overused phrase in finance but it's true. If we accurately factor in for 'survivorship bias' which is where funds are merged or liquidated due to poor performance. Essentially skewing the comparison as the data set if you don't adapt for this
When you adapt for this it creates results which can be shown in 'SPIVA's Persistence Scorecard' show and the below data set is from US equity funds. This example was taken over a 5 year period. Looking at all domestic funds at the start point of September 2015 only 0.88% remained in the top quartile 4 years later. Only 8.37% remained in the top half.
Success may not be your friend
Some funds perform well under smaller allocations but frankly struggle to handle the influx of new capital which can come with success. This in fairness may not be a problem for every fund depending on the size of the underlying holdings however as Warren Buffet often remarks, it is easier to be more nimble with smaller figures than larger. If you have an opened ended fund, it is possible to be a victim of your own success as you face the difficulty of managing high inflows and outflows.
Understand the distribution of Alpha
Stay with me on this one. I mentioned in 'Understanding Your Investments - Pt 2' the paper 'Do Global Stocks Outperform Treasury Bills' and one of the conclusions was that there is a large positive skewness in stock returns. Basically, a small proportion of the market is highly successful which means in a well-diversified fund you can benefit from the overall march forward of the market. If you are lucky enough to be able to pick the winners this can lead to considerable outperformance but statistically, the probability of this is low.
The key thing to be aware of is that as concentration rises the probability of outperformance falls, see the below video and link from the Indexology Blog for a great explanation of why this occurs.
Pressure to perform
One of the key difficulties in investing is that a lot of time the best decision can be no decision at all and changing approach can actually be counter-intuitive as it can counteract the forces of mean reversion. The market can be erratic and when you are paid to preform 'waiting it out' which may objectively be the best course of action I can imagine may be very difficult. This extends as well to keeping faith in a fund manager.
In a paper by Research Affiliates. Arnott, Kalesnik, and Wu show that the emphasis on past performance is quite a reliably poor path to future outperformance.. The authors begin with an analysis of over 3,300 US open-end long-only active equity funds from the Morningstar Direct Mutual Fund Database for the period January 1990 to December 2016. They concluded that mean reversion in performance appears to play a significant part.
This indicates that the common practice of manager rotation which is basically firing recent losers and hiring recent winners (where the ‘losers’ in general may be expected to mean revert) can create the opposite of the intended effect. Now to distinguish between what is expected to ‘mean revert’ and what is to continue to underperform is anyone’s guess.
Thoughts from the ashes
If there are any positives to come from the Woodford saga hopefully it will be closer control of the liquidity requirements of funds (the UCITS rules) to try and stop this from happening again. Investing is an incredibly personal thing. Personal Finance is more personal than it is finance so YOUR engagement in the process is likely to add more excess returns than any investment approach. However, there is the heavy caveat that there has to be a good understanding of the facts and the research so it's coming from a conscious and informed point.
If you back an active manager due to 'conviction' then it has to be expected that this conviction can be right or wrong in hindsight. The truth is the data is overwhelming that the majority of active managers underperform the market when accounting for costs.
What I would suggest maybe the best lesson of this saga is to remember that the true magic with investing comes more from the ability to compound returns over time than it comes from the investments which 'shoot the lights out. The history of finance teaches us this, be it technological revolutions, stock market manias or simply even observing the composition of the major indices over decades. Of course, look to maximise returns but it is important to know where your focus should lie.
The secret is being able to stick to an investment plan with aligns with your values and that you can be consistent with for the longest possible time. Too many spend too long focusing on the noise and changed approach in line with what's new and what is working now as opposed to what has always worked. My job is to remind you that any goals should be judged on how it affects your plan as the real danger is not achieving your goals, the life and the aims we are planning for. Not chasing a quartile performance which is totally irrelevant for an investor who aims to provide multi-decade and multi-generational wealth.
So it's simple really if you want to see the Woodford from the Trees. Don't get caught wandering off somewhere for the wrong reason. Make sure you're on the right path....
IMPORTANT DISCLOSURE
Any views stated here are individual and should never be considered as advice. Investment involves risks. The investment return and principal value of an investment may fluctuate so that an investor's portfolio, when redeemed, may be worth more or less than their original value. Past performance is no guarantee of future results.
The information provided in this article has been compiled from sources believed to be reliable and current, but accuracy should be placed in the context of the underlying assumptions.
All articles are being provided for informational purposes only and should not be considered to be investment or tax advice. No investment decisions should be made solely based on the information in any of these videos or blog posts.
