In funds with a liquidity mismatch, the First-Mover Advantage is huge, as Woodford’s investors found out.
By Nick Corbishley, for WOLF STREET:
On Oct 15., it was announced that Neil Woodford’s flagship Equity Income fund (WEI), which has blocked redemptions since June, would be closed for good. And signs are emerging that the problems that bedeviled WEI may be spreading to the wider UK equity fund sector. Across all UK-domiciled funds, investors pulled £2.1 billion in September taking net outflows this year to £7.3 billion, according to data from Morning Star.
Here are the active funds that bore the brunt of the exodus:
- Standard Life Aberdeen’s flagship Gars fund, which saw outflows of £392 million in September and which is down £8.9 billion over the past 12 months, shrinking the fund’s asset base to £6.5 billion.
- Majedie, an £11 billion active equity boutique that suffered £269 million of redemptions, a monthly record.
- Lindsell Train, the largest managed UK shares fund, also registered a record £374 million of net outflows in September despite returning 25% over the first nine months of 2019. Confidence in the fund was hit by the decision in July of the UK’s biggest broker, Hargreaves Lansdown, to remove the Lindsell Train UK Equity Fund from its Wealth 50 Best List due to liquidity concerns.
- Invesco’s UK-focused funds, which suffered the biggest wave of redemptions in September — £967 million — and is down £8 billion over the past 12 months.
Invesco’s UK business was, ironically, managed, with incredible success, by Neil Woodford until 2013, when he left the U.S. firm to set up his own investment company, taking many of his Invesco clients with him. So formidable was Woodford’s reputation in the fund sector at that time that he was able to raise £10 billion in his first two years of going solo.
For Invesco, the opposite happened. Since Woodford’s departure, the firm’s UK-focused funds have leaked £15.4 billion. More than half of those funds were redeemed in the last year alone. Things were hardly helped when the two main funds — the Invesco High Income fund and Invesco Income fund — featured prominently in Bestinvest’s 2018 “Spot the Dog” report, which highlights the sector’s worst performers. In September, it saw its worst outflows since Woodford’s departure.
What appears to have spooked many investors is the fact that the man picked to replace Woodford, his protege Mark Barnett, appears to be following the exact same playbook of his one-time mentor. Like Woodford, Barnett has been placing massive bets on companies that are often difficult to trade. In total, Barnett has poured more than two thirds of the £6.1 billion Invesco High Income Fund into higher yielding but largely illiquid micro-, small-, and mid-cap stocks, up from less than a quarter when he took over in 2014.
As the collapse of WEI has shown, betting big on illiquid investments carries large risks for open-ended funds that, on the one hand, offer their shareholders the opportunity to redeem their funds whenever they want while, on the other hand, pouring those same funds into investments that can take weeks or months to sell.
It is this sort of liquidity mismatch that the Bank of England has been warning about for years. If investors in an open-ended fund decide to pull their money en masse, which they’re ostensibly allowed to do at just about any time, the fund could struggle to liquidate its assets in time if those assets are not very liquid. It’s precisely what happened at Woodford’s flagship fund, which saw its asset base crumble from £10 billion to £3.7 billion in the space of just three years, before the gates were slammed shut on the remaining investors in May.
This ability of investors to yank out their money at virtually the drop of a hat can create “an incentive [for them] to redeem when they expect others to do so,” said the Bank of England’s Financial Policy Committee (FPC) in July, adding that this mismatch in liquidity “has the potential to become a systemic issue.”
It’s not just the Bank of England that’s flagging up this problem; so, too, are EU regulators as well as senior figures in the fund industry. Amundi’s chief investment officer, Pascal Blanqué, recently warned that the asset management sector could be on the cusp of a wider liquidity crisis, as a result of the fears sparked by Woodford’s downfall. “This business is a trade-off between risk, return and liquidity,” he said. “We have the ingredients of looming liquidity mismatches across the industry.”
An added cause for concern cited by Blanqué is that banks have pared back their dealer and market making activity following the global financial crisis. Having scaled back the amount of risk they take, due in part to more stringent capital requirements from regulators, banks’ diminished ability, or willingness, to absorb liquidity demand during selloff periods could pose wider problems for fund managers.
The more that those fund managers stray into less liquid assets, in a desperate hunt for returns in a yield-starved world, the greater the threat this vulnerability could pose to financial stability. “We’ve seen a frantic search for yield on the buy side, pushed by [central banks’ quantitative easing programs],” said Blanqué. “The combination of a frantic search for yield, and the deterioration of market liquidity, can create mismatches.”
Such mismatches have already caused liquidity problems this year for London-based H2O Asset Management and Swiss-based GAM. Three years ago, in the aftermath of the Brexit vote, six commercial real estate (CRE) funds were forced to suspend redemptions for the same reason.
Now, those same mismatches have led to the downfall and disgrace of Woodford, one of Britain’s most revered stock pickers, while decimating the savings of hundreds of thousands of retails investors. It has also shone a bright spotlight on the dangers of entrusting one’s money with open-ended funds that, in turn, plow that money into illiquid assets.
It appears that many investors, now aware of the first-mover advantage with open-end mutual funds, and already leery about the risks of a no-deal Brexit and fearful that what happened at Woodford could happen to them, are making their way as calmly as possible to the exits. By Nick Corbishley, for WOLF STREET.
What’s astonishing is how long it lasts. Read… THE WOLF STREET REPORT: What Will Stocks Do When “Consensual Hallucination” Ends
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I did a bit of web-searching and from what I can tell, a UK “equity fund” is just a mutual fund that invests primarily in stocks. Some such funds are quite aggressive, risky and less liquid than others.
Did I miss anything? What would be a US mutual fund that is at the same level of aggression as WEI?
What would be a US mutual fund that is at the same level of aggression as WEI?
They don’t last long enough to make a name for themselves. This sort of business model sort of guarantees it because big fish eat little fish. WEI’s connections give it name recognition and its largish resources will take a little longer to squander.
The financial economy is grossly out of balance with the real economy. They’re all aggressive and the elbows are getting sharper, so more of them can be expected to cross the line into self-destructive practices. The quantity of money on the sidelines is enormous and getting bigger and there’s a lot of pressure for it to go somewhere, anywhere, enough to waste it on [your favorite adjective here] speculative opportunities.
Capitalism is constant competition and dog-eat-dog. There can only be one top dog. Thus, the surviving dogs become more aggressive as their numbers decline. What happens is the whole system breaks down at this point, as all of the advantages of competition and markets disappear when its only one or two dogs dominating. By that point, its more like a central planned system as there is only one un-checked decision maker, but without the advantages of groups of planners trying to collaborate for the common good.
You might like the recent article in Foreign Policy titled “Wall Street Was America’s First Foe in World War II”. The US was still heavily monopolised in the 1930s. The monopolists were pretty nasty about it, and they did operate as central planners for the industries they controlled.
‘… advantages of groups of planners planning for the common good’.
Check up on the history of that. It ain’t pretty.
Umm, all of them I think. That’s exactly what a US mutual fund can be. They are either all stocks, all bonds, MM, or a blend. When I was a young baby boomer I and most of my friends went 100% stocks.
Would this have anything to do with the repocalypse? I mean, maybe those illiquid investments were in US assets?
Along with Deutsche Bank imploding and trying to collateralize worthless paper assets.
Is the Fed the world’s biggest buyer of non performing paper to keep the charade going?
Me thinks that if the collateral was not Treasury (or to some extent Agency), the Fed couldn’t repo it.
The loan facilities created during 07-09 were different. That was an admitted crisis.
One of the things that von Mises got right was the observation:
The end of a boom does not require bankers to call loans, it just requires that they get a little nervous and stop making them.
My own view has been that leveraged buyers require prices to advance everyday. Bidders, including too early shorters covering, become exhausted.
Prices start to decline and the power shifts from central bankers to margin clerks.
This essay suggests another player. The one who, for whatever reason, just wants to take his money out, at close to highs.
I have the US yield curve back to 1857 and the rule is that once the curve seriously inverts (check) a bear market and recession has followed ( ???).
The axiom on this I believe is that when the YC reverts that sends the economy into recession, or markets into selling. 94′ was an interesting situation, the YC dropped and instead of reversing continued along at albeit much lower levels for several years before reverting.
Interesting. In this modern era, I’ve come to regard the Cause and Effect of the Yield Curve inversion to be the opposite of what is supported. The statisticians point to statistics that say the yield curve inversion causes recessions.
But, in watching the markets through the end of this cycle, I’ve come to the opposite conclusion. Its the traders on the markets that see a recession coming. When they do this, they bet on lower interest rates coming as well, as that has been the standard robot like response of Central Bankers. Thus, when the traders see the recession coming, they expect lower yields a couple of years out as the bankers cut interest rates. Its these bets that seem to cause the Yield Curve inversion.
A bit of a chicken or an egg argument, I know. But, the point of view of an old engineer is that while statistics can point to a trend, one really needs to understand what’s beneath that trend to properly proceed. Statistics can show that when a car exceeds 100 mph, for most drivers it will be more likely that they press the brake pedal next rather than the accelerator. But saying that the car exceeding 100 mph causes the brakes to be pushed will not be correct.
It is not only central banks that create a lower interest rate. There is also less investment going on so less demand for lending and those that do still land are less prime.
Running a fund with “on demand” withdrawals while heavily funding (perhaps even profitable) illiquid investments is like asking your 6-month-old puppy to run across a busy interstate.
Even better – all this behavior was fully disclosed to investors.
It’s no fun watching the wheels come off, but it’s also hard to feel too sorry for investors or fund managers.
“funds with a liquidity mismatch”
oh my where did they learn that
So, let us follow the money.
More than any other industry, large banking has the guarantee of high profitability and success. The bankers know that the government will not allow their banks to fail. So, they can take enormous risks based on the discrepancy between short-term rates (at which they borrow) and long-term rates (at which they lend).
When the spread reverses, which it always does at some point, driving up short-term rates and driving down long-term rates, the result is a recession. If a very large bank faces bankruptcy, the central bank intervenes and lends to it at low rates until the old yield curve (spread) returns: low short rates and high long rates. If central bank intervention is not sufficient, then the government intervenes and uses tax revenues to offer more bailout money to the biggest banks.
This arrangement has created a class of super-rich people. The arrangement is ideal for them. When they win, they win big. They do not lose, except when their bank is judged not quite too big to fail. Then the bank gets bought up at a discount by a TBTF bank. The government arranges the terms of sale.
This arrangement has been known by economists — and few others — for two centuries. There is a phrase for it: “moral hazard.” It is just about the only phrase in the field of economics that is designated by the adjective “moral.” Economics is said to be value-free science, and therefore economists are not supposed to invoke morality in their economic analysis. But “moral hazard” is an exception. We are never told why the hazard involved is a moral hazard rather than (say) a government-subsidized speculative hazard.
Obviously if everyone pulls their money out of a fund, there is liquidity issues.
There is exactly the same as bank holders withdrawing all their funds from their bank accounts.
Which people WILL be doing when Nirp shows up if they’re smart anyway Even with today’s low rates Keeping your money in the bank makes no sense Not worth the risk and losing to inflation
I can see the draw for a fund to pile into illiquid assets. Early on it’s an easy win … as long as you’re buying, the price climbs. Slowly continue purchasing to push up the share price and money piles in as your entire previous investment looks brilliant.
The only problem is the exit strategy … if it’s high growth startup concept like WeWork, you can bet it’ll get a big enough market cap to be blessed with passive index fund money after the IPO regardless of earnings. After a point though, cash burn does matter.
If it remains a small cap or micro cap, you will have to really put some hype out there to get investor interest in order to divest. If you’re planning on exit by aquisition then you need a compelling reason for the acquisition and an expectation of valuation that will pass a board of directors.
There’s also the idea that you can remain in overpriced micro caps as long as new investors allow you to continue the trickle of buying pressure to make the underlying valuation continue to rise – but this starts to resemble a Ponzi setup.
You need to show continued price appreciation to keep your investors coming, but this steadily raises the asset allocation that can’t be liquidated. Eventually you can’t engineer the share price rises anymore as your allocation becomes increasingly skewed, and your fund performance suffers. Withdrawals start and your liquid capital shrinks, and the only sizeable buyers of your microcaps are found at micro prices.
Conclusion: Valuing tens of millions of shares on the last one sold doesn’t make sense. It is easy for a fund to manipulate up the share price while they continue buying, but the illusion falls apart once they need to sell.
Am I the only one who finds the idea of a fund named “H2O Assets Management” having liquidity issues hilarious?
I’ll have to settle for the delicious irony with a side of schadenfraude. My handle comes with certain limitations.
These days, I assume any name and any slogan is designed to be misleading. Usually the reality is the opposite of what you are being misled to believe.
Years of businesses forcing me to watch Fox News just so I could eat lunch in my allotted 30 min, and seeing over and over that they are “Fair and Balanced” taught me that.
So, the problem is those evil investors who want to be able to move their money around, or simply use their money, when they choose to do so?
I’d instead submit that what we’ve seen is a fundamental problem in fund management. The fact that the fund is open-ended is surely not an unknown to its managers. Thus, proper management of such a fund should include not stacking up too much of the fund’s money in investments that are are not liquid.
A few bets on less-liquid companies that hope to provide a good return are not a bad thing. But too many of them is poor management. Seems to me that these managers were chasing higher yields, and having less success in this negative interest rate world, then decided that the answer was to cheat. By cheat I mean sacrificing the health of the fund by making big less-liquid investments that they never should have been making. But of course, in this modern world the rich never get blamed by the media for their mistakes.
Very good comment