- This case highlights the value of regularly reviewing a portfolio’s factor exposures and liquidity characteristics for signs of style drift or deteriorating ability to redeem shares.
- We found that the portfolio had negative exposure to the value factor and neutral exposure to the yield factor. These exposures were inconsistent with the fund’s investment objective to provide income and the manager’s expressed focus on fundamental value.
- The fund’s allocation to listed, but highly illiquid, securities soared over time. These positions attracted little attention but may have jeopardized the fund’s ability to make large redemptions in a timely manner.
Six months before the Woodford Equity Income Fund suspended withdrawals on June 3, the level of illiquid securities stood close to 80% of assets, and the fund had drifted away from its investment objective “to provide reasonable level of income together with capital growth.”1 This case highlights the value of regularly reviewing a portfolio’s factor exposures and liquidity characteristics for signs of style drift or deteriorating ability to redeem shares. These insights may enable investors and their advisors to act early to ensure their portfolios remain within their stated objectives and constraints.
A portfolio set adrift
Neil Woodford, the manager of the fund, stated in a recent letter to investors that “every asset in the portfolio has a fundamental value that significantly exceeds its share price.”2 We analyzed the fund’s style characteristics from March 2015 to December 2018 using MSCI FaCS, MSCI’s factor classification standard. Despite the fund’s objective to generate growth and income and its statement on fundamental value, we found that the portfolio had substantial negative exposure to the value, size, momentum and quality factors. With regard to the yield factor — which reflects exposure to companies with high dividend yield — the fund only had neutral exposure.
This analysis shows that, in aggregate, the fund held securities with average income-generating characteristics, high valuations, negative price trend, poor quality characteristics and low size. Importantly, these factor exposures drifted and became progressively more extreme through time. The fund’s size exposure as of December 2018 placed it in the top 1% of all active global equity funds in the Lipper database, indicating its strong tilt toward very small stocks.
MSCI FaCS factor exposures show that the fund suffered significant style drift in the past two years
Source: MSCI, Lipper data, from Refinitiv. Active exposures relative to the MSCI UK IMI Index, March 2015 to December 2018. The calculations are based on holdings covered by MSCI FaCS. Their weight decreased from 91% in March 2015 to 72% in December 2018.
A stampede for the exit
Open-ended mutual funds, such as the Woodford Equity Income Fund, aim to provide high liquidity by allowing investors to deploy and withdraw capital daily. However, as the next chart shows, the fund held substantial investments in unlisted securities and securities outside the MSCI ACWI IMI, which aims to represent the investable equity opportunity set for large-, mid- and small-cap securities listed in developed and emerging markets. In addition, as outflows increased, the fund’s weight in unlisted and illiquid securities became larger.
As outflows increased, the weight of illiquid holdings shot up
Source: MSCI, Lipper data, from Refinitiv. Data from March 2015 to December 2018
We used MSCI LiquidityMetrics to drill deeper into the liquidity characteristics of the fund, applying the U.S. Securities and Exchange Commission’s liquidity bucketing methodology for every month-end in 2018.3 We broke out illiquid positions into two sub-categories. On the exhibit below, the bottom layer shows positions that were illiquid because they were not traded on an exchange, while the much larger second layer consists of exchange-traded stocks designated as illiquid by our model. Selling the more liquid positions left the fund less liquid, which is consistent with the fund’s growing exposure to small-cap stocks, shown in the first exhibit. As the fund sold the listed positions, the unlisted part of the portfolio reached 18%, well above the U.K.’s Financial Conduct Authority’s regulation limiting funds’ unlisted holdings to 10%.
Outflows were met by selling the most liquid positions
Source: MSCI, Lipper data, from Refinitiv, January 2018 to December 2018. Monthly breakdown of the Woodford Equity Income Fund in GBP according to SEC-defined liquidity buckets. We divided the illiquid category into listed and unlisted groups. We used 5% anticipated trading size and MSCI’s suggested significant transaction cost limits to produce the analysis. The Liquid category regroups "Less Liquid," "Moderately Liquid" and "Highly Liquid" holdings.
An ounce of prevention
It’s important to note that this was not a case of a rogue trader acting out of sight: It was well known that the fund held illiquid securities. While investors focused on the unquoted positions and how the manager was moving most of them to a trust, the fund’s allocation to listed, but highly illiquid, securities soared. Though this increase attracted little attention, these holdings may have impaired the fund’s ability to meet withdrawal requests.
Regardless of what dealt the final blow, our analysis highlights the importance of sound factor and liquidity risk management practices. Even if the fund had managed to liquidate all unquoted positions, the remaining portfolio still would have been extremely illiquid, and the fund may not have been able to satisfy large redemptions in a timely manner. Regularly reviewing portfolios for signs of style drift or deteriorating liquidity, may have meant the difference between riding off into the sunset or getting trampled underfoot.
1 See the Prospectus of LF Woodford Investment Fund, available on www.woodfordfunds.com.
2 See “Woodford apologises to clients but defends ‘undervalued’ portfolio.” Financial Times, June 12, 2019.
3 According to SEC rules, a security is deemed illiquid if a portion of the position which the fund reasonably anticipates trading cannot be liquidated within a week with reasonable transaction costs.
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