WHEB Commentary

George Latham

Lessons from Woodford

And now the lawsuits are rolling in. The crisis which has destroyed Woodford Investment Management is shocking. It is also immensely damaging to confidence in the investment industry. It is tempting to suggest that the circumstances which have engulfed Woodford are unique. But we would all do well to look at what steps we can take to avoid anything like this ever happening on our own watch. This whole experience is particularly harmful at a time when trust in financial services is at a low ebb anyway.

Although it was a liquidity crunch which caused the crisis at Woodford IM, the two key underlying issues at play were capacity and style drift. A change in investment style brought increasing exposure to higher risk, less mature, and more illiquid small companies. A lack of discipline in controlling capacity in the investment strategy created the conditions for what was to follow.

The importance of capacity

There are areas where the interests of a fund management business and its investors can conflict with each other. Capacity is one of these. Fund managers earn extra fees on every marginal amount invested in their strategy. But if assets under management grow too large, investment performance suffers from dis-economies of scale and liquidity risks increase. Fund managers should view their capacity as scarce and maintain the size advantage for their clients. A fund which is more concentrated or has more exposure to smaller and less liquid companies, should limit available capacity at a lower level when compared with one which invests in larger companies or across more positions. To compensate, funds which are disciplined over limited capacity should experience less pressure on fees.

WHEB has been explicit about capacity from an early stage. We have set the ideal capacity for WHEB’s main strategy at $3bn in assets under management. The maths we have used to determine this are quite simple. The smallest company we have invested in over the past 5 years has a market capitalisation of around $500m. Our smallest position size is around 1% of the portfolio. If we were managing $3bn and had a 1% position in such a company, then we would hold 6% of that company’s equity across our client portfolios. That is a level we are comfortable with. This is not only from a perspective of being able to provide liquidity to meet potential redemptions. It is also to be able to manage the portfolio and sell the position should we want to reinvest elsewhere.

Avoiding style drift

As well as discipline on capacity, investors need also to have confidence that a manager will have a consistent investment style. How? The answer lies in a combination of strong governance, transparency and alignment of interests.

At WHEB, we are keen on aligning our interests with those of our investors. An owner-managed investment business has a natural alignment of interests with its clients, as the incentive to build franchise value outweighs the temptations of short-term gain. Woodford ultimately found this out through the collapse of his own firm. Co-investment in the funds alongside our investors is also important. WHEB has embedded co-investment within our partnership. Yet, in the case of Woodford IM, this kind of alignment was not enough to control for what happened.

Transparency is so important in the investment world. In short, it should make a manager think twice before going ‘off-piste’. If style drift happens in public, it would quickly raise questions. That should make it less likely unless it is for good reasons. To be fair, Woodford had also done some good things on transparency. Along with WHEB, he has long had a transparent approach to publishing his holdings on a regular basis. Woodford’s growing investments in smaller companies were public information. But again, on its own this wasn’t enough to avert disaster.

To work effectively, alignment and transparency must happen within an appropriate framework of governance and oversight. Perhaps one should always be careful of an eponymous fund management company, dominated by a star fund manager who is above effective challenge. But the cult of the star fund manager is still celebrated in the media. The industry’s continuing focus on past performance track records to promote funds is still present. This needs to change. More sophisticated consultants and fund selectors will look for a strength of team and systematic process over individual flair.

At WHEB we have developed a twin structure of both internal and external governance. This is layered over a systematic investment process and portfolio construction rules. The investment team meets monthly with the Investment and Risk Committee, chaired by partners who are outside the investment team. We also have quite a unique external form of governance. We meet with our independent investment advisory committee three times a year. They hold us to account for managing the portfolio consistently with our stated investment philosophy and process. We strengthen this form of governance through transparency, by publishing the minutes of that meeting.

From hero to zero, but don’t let the industry go backwards as a result

What has happened at Woodford is a disaster, and many savers continue to suffer for it. A real irony is that he confronted several of the flaws in the asset management industry. He challenged the bonus culture of the city. He was a champion of a longer-term investment culture, something which WHEB absolutely supports. He was an early proponent of simpler charging structures for investment funds. Here again WHEB is also an early mover and currently implementing a single, fixed rate management fee. The ramifications for the investment industry will no doubt be far reaching. But we hope that progress on these fronts isn’t lost, and the inevitable regulatory and consumer reaction is considered and progressive.

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