The suspension of Neil Woodford’s flagship Equity Income Fund in June 2019 has highlighted the grey area between following the rules and doing what is right, ie, the difference between the letter and the spirit of the law. 

Adrian Lowcock, Chartered FCSI, head of personal investing at Willis Owen, says, “I don’t believe he broke the law, but the perception around ethics is a very complex affair and certainly blurred at the edges.”

And Greg Davies PhD, head of behavioural finance at Oxford Risk and an expert in applied decision science, behavioural finance, and financial wellbeing, adds that overlooking the spirit of the law is all too easy. “It could be argued that ‘spirit’ is very unscientific, but it is far more dangerous to rely on blind box-ticking with evidence only of the answer, not the process,” says Greg. 
Ticking boxesThe FCA’s Andrew Bailey told UK Members of Parliament that Woodford’s decisions may point to a failure of rules rather than regulation and there may need to be some modifications. Rules are a crucial mechanism for delivering an outcome but they can also be applied so rigidly they merely become a box-ticking exercise. 
Investors had a great deal of confidence in Woodford for a long time, but nothing lasts forever Neil Woodford was one of the first fund managers to be labelled as a ‘superstar’, a reflection of his ability to produce exceptional returns for clients and also ‘buck the trend’. He made his name by making big calls on certain sectors and also by becoming a contrarian investor – making good investments by exploiting the market’s crowd-following behaviour.

For example, in the late-1990s, he invested in technology stocks, a move that attracted criticism, but when the dotcom crash came, he was able to navigate the drama well. Similarly, when everyone was investing in bank shares, he steered clear and avoided the pitfalls of the 2008 crisis. He went on to form Woodford Investment Management in 2014. Investors had a great deal of confidence in Woodford for a long time, but nothing lasts forever. 
Strategy changeThe performance of the fund – which at its peak totalled more than £10.2bn in assets under management in 2017 – declined by almost 13% between July 2017 and June 2018. By the end of June 2019, the fund’s performance had gone down by another 21%. When the fund was established, it was invested 72% in large-cap companies – companies with a market capitalisation (market cap) of more than US$10bn, but by the end of 2017, the portfolio composition had changed to include what some felt to be ‘unorthodox’ stocks for an equity income fund. The large-cap level reduced to just 3.16% by July 2019, with more than 71% being allocated to small-cap, higher-risk companies – companies with a market cap of between US$300m and US$2bn. 

Woodford took on more risk in an attempt to improve performance. While acting within the law, he was not necessarily taking into consideration investor appetite for risk. It was a gamble that didn’t pay off – in fact, the continued poor performance triggered off some significant withdrawals. The redemption that started alarm bells ringing was the £300m stake owned by Jupiter Asset Management in October 2017 and others also saw problems emerging with Woodford at the time. Architas, for example, noted that the information ratio on the fund, a measure of the risk-adjusted return, was falling as well as the downside protection ratio, the techniques a fund manager uses to prevent a decrease in the value of the investment. A few months later, Woodford reported that the fund had declined in the year ended June 2018. 

Funds can spin into crisis when there is a vicious cycle of investor discontent, redemption requests and rapidly disappearing liquidity. As performance declines in a fund and investors flee, assets may have to be sold. Then it is a question of determining how liquid the portfolio is.

Woodford was, according to Adrian Lowcock, always transparent about the composition of his portfolio, and the actions taken were widely publicised, but for a long time, investors retained confidence in Woodford’s track record until the start of 2019. 
Funds can spin into crisis when there is a vicious cycle of investor discontent, redemption requests and rapidly disappearing liquidity But Woodford’s portfolio, which was in the process of refocusing, had on more than one occasion breached the 10% limit for unlisted assets under the UCITS (Undertakings for the Collective Investment in Transferable Securities) directive. This directive restricts funds from accumulating too many illiquid stocks, but Woodford exceeded the limit, notably in early 2018 and then again in the first quarter of 2019. This is where Woodford, to quote the FCA’s Andy Bailey, used the EU’s rules-based regime “to the full”. 

In March 2019, Woodford Investment Management announced that they had performed a share swap between the Equity Income Fund and Woodford Patient Capital Trust. The rationale was to reduce the level of unquoted stocks on the Equity Income Fund in exchange for shares in the listed Patient Capital Trust. Woodford also took the unprecedented step of listing a trio of unquoted stocks on the Guernsey-based TISE (The International Stock Exchange) to stay within the UCITS directive. 

In both cases, Woodford hadn’t broken the rules, but the actions were treading a fine line between the letter and the acceptable spirit of the law. 

Greg Davies believes that an over-focus on ticking boxes rather than the reasons the boxes exist in the first place can lead to laws being followed at the expense of meeting the very outputs the laws are there to produce.

Woodford admitted to the Financial Times in March 2019 that returns had been disappointing, but as Adrian explains, this is understandable. “A period of under-performance is not unusual for a contrarian fund manager, as they are investing in the opposite direction to the market. Woodford was banking on the UK economy’s post-Brexit recovery.”

Within a four-week period in April 2019, the fund lost £560m of its value as fund managers started to advise their clients to withdraw. Fidelity Personal Investing, for example, allowed clients to withdraw from Woodford and would not let investors buy new units.

In June 2019, Kent County Council (KCC) requested to take away its £250m pension fund investment and this proved to be the final straw for Woodford. KCC’s Superannuation Fund Committee, seeing the trend of big withdrawals, was unanimous that it should redeem its investment.

Generally, fund managers retain cash in order to provision for longer-term tail-risk fears, often between 1% and 5% of the value of the fund, but when money starts to leave at a fast rate, the fund in question has no choice but to sell shares. If, however, the assets are illiquid, they cannot easily be turned into cash, which raises a moral issue about the level of risk taken by fund managers in building a portfolio of less liquid assets.
No choice?Was the suspension warranted and did it really take into consideration that investors might want to redeem their cash? Rodney Hobson, an experienced investor and author of Shares Made Simple and other books, believes Woodford had no choice but to suspend the fund at this point until he was able to sell the illiquid assets. 

Woodford explained in a June 2019 statement that the fund strategy was being repositioned to protect investors and that once the fund reopened, the portfolio would be far more liquid. Usual practice in such incidents involves liquidating any unquoted stocks and small cap equities without depressing their values, a very difficult task. There is always a risk that a fund that reopens after suspension will lose value. 

While the fund has been suspended, freezing investors’ money, Woodford is still receiving fees, which is another ethical question, according to Rodney, and approval of investment decisions now lies with board members. 
While the fund has been suspended, freezing investors’ money, Woodford is still receiving fees, which is another ethical questionThere is another side to the Woodford story that may open up further debate around the role played by execution-only companies. One such company, Hargreaves Lansdown, has been criticised for being too close to Woodford. Hargreaves Lansdown included Woodford’s funds on its Wealth 50, which is a listing that uses the track record of the fund manager as its guiding criteria but fails to take into consideration the cost of investing in the fund. Regulatory changes under Markets in Financial Instruments Directive II have forced such platforms to separate their own fees from the investment’s annual management charges. There is often a lot of small print for investors to digest, however, including dealing, dividend reinvestment, inactivity and exit charges.

Critics felt Hargreaves Lansdown should have acted quicker in identifying Woodford’s diminishing performance and various actions around illiquids. In June 2019, HL did finally remove Woodford from its Wealth 50. “The role of Hargreaves Lansdown needs to be challenged. They may advertise themselves as execution-only, but they effectively make money from encouraging people to trade,” says Rodney.

As the execution-only broking sector grew, the business model evolved into one where such firms provide strong generic guidance not only on funds but also on portfolio construction. 

Arguably, the gap between execution only 'guidance' and regulated 'advice', making a personal recommendation, has now closed so far as to have become indistinguishable to the layman and in need of a fresh regulatory approach. 

It is widely believed that Woodford broke some of the basic principles of managing client money. These include taking on too much money, mixing and changing investment styles and, most importantly, owning too many illiquid stocks. None of these aspects are illegal, but are they right? Bailey, of the FCA, summed it up when he said money managers should not prioritise staying within the rules over doing the right thing. In this age of corporate values and public scrutiny and mistrust of the financial sector, the spirit of investing has to be uppermost in financial service providers, more than ever before. 
Seen a blog, news story or discussion online that you think might interest CISI members? Email bethan.rees@wardour.co.uk.