Abu Dhabi, UAETuesday 25 June 2019

What UK fund manager Neil Woodford's failure says about active fund management

Has the case for active management collapsed along with the star investor's Woodford Equity Income?

Neil Woodford's Woodford Equity Income fund is down 20 per cent over three years, according to Trustnet, after disillusioned investors headed for the exit. Alamy Stock Photo
Neil Woodford's Woodford Equity Income fund is down 20 per cent over three years, according to Trustnet, after disillusioned investors headed for the exit. Alamy Stock Photo

For years, investors were in thrall of the cult of the star fund manager. They were the emperors of the investment world, fabled for their ability to make investors rich by repeatedly outperforming the stock market.

Then investors took a closer look and found that many of these emperors weren't wearing any clothes.

Research repeatedly shows that eight out of 10 active funds fail to beat the market over the longer run. The longer the term, the more prone they are to underperform.

Last year's winner is actually more likely to be this year's loser.

Gordon Robertson, InvestMe Financial Services

Over the year to December 31, 2018, 64 per cent of large cap funds underperformed the S&P 500, according to research from SPIVA. That figure rose to 79 per cent over three years and 82 per cent over five.

Investors began to wonder why they were paying hefty fund management charges to those failing to do their jobs properly.

Growing numbers have shifted into “passive" index tracking exchange traded funds (ETFs) that will never beat the market but never trail it either.

Given that the charges on these funds are much lower, you get to keep more of your gains as well.

Defenders of active management, however, could always answer their critics with two words: Neil Woodford.

The UK star fund manager famously turned £10,000 (Dh46,686) into £114,000 in 20 years at Invesco Perpetual Income, which invested in the dividend-paying stocks of UK blue-chip companies.

However, the investment legend of more than three decades has now seen his star fall in a matter of months. So has the case for active management collapsed with him?

Why did Neil Woodford fall from grace?

It is hard to overstate just how earth shattering Mr Woodford's sudden change of fortune is for UK investors.

He was described as “the man who made Middle England rich” by making big calls and refusing to follow the herd, shunning technology stocks during the 1990s dot.com bubble, and banking stocks in the run-up to the financial crisis.

In both cases he thought they were risky and overvalued, and history proved him right.

Five years ago he left Invesco Perpetual to set up his own eponymous fund Woodford Equity Income amid massive hype, but after a successful first year things went badly wrong.

Some say he got too clever. Others hint at arrogance. Now his own boss, he lacked managerial oversight.

Mr Woodford is known as a "value" investor, buying UK stocks that are unloved by the wider market, in the hope they will recover when sentiment changes. He also made one of his big calls, calculating that Brexit would be fixed and his stock picks would then recover. It wasn’t, they haven't.

Worse, his fabled stock-picking abilities deserted him as he backed flop after flop, notably Provident Financial, Capita and Allied Minds, and a host of other wipe outs.

Graphic by The National 
Graphic by The National 

How bad is it for investors?

Woodford Equity Income is down 20 per cent over three years, according to Trustnet, against a rise of 30 per cent on his benchmark index, UK All Companies. That is a massive underperformance.

As disillusioned investors headed for the exits, his flagship fund collapsed from £10.2 billion a year ago to around £3.7bn in a year, and then Mr Woodford's really damning mistake became clear.

He had strayed into unfamiliar territory, investing in small, unquoted companies. It was impossible to find buyers for these “illiquid” stocks to pay all the customers who wanted their money back and last week he was forced to “gate” his funds, locking investors’ money in.

Worse, he continues to bank nearly £100,000 from investment fund charges every single day from investors who cannot access their cash.

Middle England isn't happy. It is also furious at the UK's most popular advisory platform, Hargreaves Lansdown, which made huge sums from plugging his fund, even as it started to fall apart, although at least Hargreaves is waiving its fees.

Is it time to abandon actively managed funds altogether?

Tuan Phan, a board member of SimplyFI.org, a non-profit community of UAE investment says the mistake Mr Woodford and every other star fund manager makes is to confuse luck for skill. "It's not a matter of ‘if’ they will crash and burn, but ‘when’. If they spend long enough in the industry, it is a mathematical certainty," he says.

Even if one of them manages to beat the market for a decade, they can be wiped out by a couple of bad years or one major mistake, Mr Phan adds.

He says star managers under immense pressure to keep winning, which can only be done by taking ever higher risks. “A lucky sequence made Mr Woodford a star but the famous quote by US investor Warren Buffett quote applies: 'Only when the tide goes out do you discover who has been swimming naked’.”

Mr Phan says the message is getting through to private investors, hence the massive outflows into ETFs. "Many supposedly active fund managers have responded by becoming ‘closet indexers’, which allows them to beat most competitors and collect huge fees without taking risks.”

Sam Instone, chief executive of AES International, says active investing is speculating, which is akin to gambling. “Sometimes you get lucky but over time the house always wins because the odds are stacked against the investor.”

Mr Woodford's story has done no favours for the active management industry. Reuters    
Mr Woodford's story has done no favours for the active management industry. Reuters    

What is the alternative?

High fees and human emotion ultimately work against active managers, Mr Instone says. “By investing in a globally diversified spread of ETF trackers, the odds swing back in your favour. Effectively, you own the casino.”

Gordon Robertson, director of financial advisory group InvestMe Financial Services in Dubai, says too many advisers recommend active managers because they performed well last year, but markets are cyclical. “Last year's winner is actually more likely to be this year's loser.”

He advises putting too much faith in a star manager. Instead, build a spread of funds covering different asset classes, sectors and regions. “Never invest more than 10 per cent in one fund, which will limit the damage if it has short-term issues.”

Can active managers have their day again?

Active fund managers find it particularly difficult to beat major blue-chip indices such as the US S&P 500 or FTSE 100, which are heavily researched with few hidden winners. However, Oliver Smith, portfolio manager at trading platform IG, which has offices in Dubai, says active management still has a place when investing in smaller companies. “This is where a good manager can prove their worth.”

Jahangir Aka, managing director, Middle East and Africa, at investment management firm Neuberger Berman in Dubai, warns that market trends could move against passive investments and active management could soon prove its worth again.

Passive funds have risen to prominence during the longest bull market in history, when low interest rates and other central bank stimulus have driven asset prices higher and higher.

When the correction comes, as it will, passive funds will fall helplessly with it. "By contrast, active managers, can employ risk management techniques to protect against the full force of a declining market.”

Terry Smith's Fundsmith Equity is up 164 per cent over five years, against just 62 per cent for his benchmark, the Investment Association Global index. PA Images
Terry Smith's Fundsmith Equity is up 164 per cent over five years, against just 62 per cent for his benchmark, the Investment Association Global index. PA Images

Are there any star fund managers left?

There are still star fund managers out there, notably Terry Smith, who runs UK-based Fundsmith Equity. His fund is up 164 per cent over five years, against just 62 per cent for his benchmark, the Investment Association Global index.

However, his fund is two thirds invested in the US and may be vulnerable if its markets fall.

Steven Downey, chartered financial analyst candidate at Holborn Assets in Dubai, says: "Smith remains popular but Woodford's demise could still accelerate the trend towards passive investments.”

Mr Downey warned against expecting too much from any one fund, whether passive or active. “The most important thing is to save a large percentage of your salary in a balanced spread of investments. No superstar manager will take your measly 2 per cent contribution and make you a millionaire.”

Updated: June 12, 2019 01:45 PM

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