Woodford: could it happen to Australian investors?
In part 2 of Morningstar's analysis of what went wrong at UK fund manager Woodford, we consider whether it could happen in Australia.
Following on from our previous article looking at what went wrong inside the UK's Woodford Equity Income Fund, we look at the key lessons for Australian investors.
Woodford's undoing is a cautionary tale for all Australian investors, says Morningstar Australia fund analyst Andrew Miles.
He says there are several lessons to be learned from those that find themselves locked in the fund, and those who avoided the fiasco.
Firstly, Miles says it's important for investors to understand the size of any fund and the individual companies it holds.
This is because when you combine the sheer scale of a fund like Woodford with a portfolio of relatively small stocks, the fund can run into problems if a large number of investors want to redeem their funds simultaneously.
For example, Australian global fund manager Magellan manages $82 billion and invests in very large, very liquid global companies.
The fund doesn't own 10 per cent of Google, or 15 per cent of Facebook, but a small percentage of very big businesses – and Magellan could probably sell the entire position today without experiencing any major problems.
- Let's say Magellan manages $60 billion in global equities and wants to invest 1 per cent of its assets in Facebook. 1 per cent of the fund is $600 million. Therefore, they'll own less than 1 per cent of Facebook – which is a massive company with a market cap of $535 billion.
- In contrast, Woodford managed £10 billion. If they want to invest 1 per cent of the fund in Provident Financial – a sub-prime lender with a market cap of around £1 billion – 1 per cent would be $100 million. Therefore, they'd own 10 per cent of the company.
Miles says a large fund invested in small companies can primarily run into two problems.
Firstly, it's not easy for the fund to be nimble, which is what you want from an asset manager.
"Good asset managers make 60 per cent good decisions and 40 per cent poor, so when something falls into the 40 per cent basket, you want the manager to be able to deal with it," he says.
"If Magellan makes a mistake, you want to have the confidence they'd be able to get out of the position at a reasonable price. If you own 10 per cent of a company, that's very difficult to do."
Secondly, when markets go through volatile periods and people panic, often they act in unison.
If large numbers of clients want to pull their money out, and it's an open-end fund with illiquid companies in the portfolio, that creates a problem because the fund could have problems selling the company on market at a good price.
Miles says this could leave fund managers in a position where they're selling their liquid positions to fund redemptions, leaving a higher concentration of illiquid companies.
Keep up with trends
Miles also highlights the need for investors in a fund to understand what it owns, and whether it has shifted in style – by continually checking fund updates, looking for a shift in investment style and keeping up with other changes by regularly reading annual reports.
In the Woodford example, small cap and mid-caps accounted for 40 per cent in January 2016, but by the end of March 2019, they stood at 95 per cent.
Holdings-based style trail: Woodford holdings from 06/2016 to 05/2019 v FTSE All-Shares Index
The circle with the outline represents where the fund's holdings started and sit today. Source: Morningstar Direct
This helps ensure you're aware of the investment risks, and can judge whether this fits your investment horizon and financial goals.
Morningstar's research reports and tools can help you understand the make-up of a fund's portfolio, and whether you're still comfortable with how you're investing.
Tom Whitelaw, director, equity ratings, global manager research with Morningstar, adds that while changes to the way a strategy is run does not necessarily result in a downgrade, investors should reassess the management team if the style has shifted, and consider whether they have the skill and expertise to, for example, invest in smaller companies.
"We would want to understand if it has the requisite skills set to perform in a different area of the market," he said.
When more is better
Investors should have a sense of how many other parties hold a fund, so they're aware of any concentration risks. For example, you can be exposed to considerable risk if you're invested in a fund where one institutional investor comprises the vast majority of assets under management. What happens if that institution decides to remove its holding?
The Morningstar manager research team spends a lot of time understanding fund client bases, and any concentration risks in the strategies.
Beware the hype
Lastly, Morningstar senior analyst Simon Scott says it's important for investors to avoid paying too much attention to market noise. No matter how skilful an investor is, or how good their track record is, no one is infallible or immune to periods of poor performance.
Scott says investors should be mindful of their own behavioural biases and how they influence their investment decisions.