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Woodford Equity Income Fund

You may have read about the suspension of purchases and redemptions in the Woodford Equity Income fund on Monday 3rd June.  Whilst the fund is not held in Equilibrium funds or portfolios, some clients have enquired about the situation and are concerned about its consequences. 

Here is a brief overview that may answer some of the questions raised from this situation.

How did this come about?

  • Following the success Neil Woodford achieved at Invesco, he set up the Woodford Equity Income fund in June 2014.  The fund was very similar in nature to the one at Invesco and was invested in many of the ‘traditional’ equity income stocks such as tobacco and pharmaceutical companies.

 

  • However, in addition to these normal income stocks, he also invested in biotechnology companies.  Biotech companies are usually small, highly risky and produce losses – and therefore cannot pay a dividend – until their products are approved and successful.  Given that they did not contribute much, if anything, to the income for the fund, this was very unusual.  Even more unusual was that the fund’s holding in these companies quickly rose to around 10% of the value of the overall fund.

 

  • The majority of these investments were unquoted, i.e. not listed on any stock market, and therefore ‘illiquid’, which to say that there was no ready market to purchase and sell the shares.

 

  • In 2016, Neil became much more optimistic on the outlook for the UK economy, stating, “Theresa May’s decision to take the UK electorate to the polls again in June looks very astute…. I am now more optimistic about the outlook for the UK economy than the market consensus, which has become increasingly negative since the EU referendum last year…. I see a lengthy period of improving economic stability in the UK – one which is now much less likely to be derailed by politics.” 

 

This informed his decisions regarding the stocks he put in the portfolio which started to include more economically-sensitive and risky companies.

  • From the inception of the fund in 2014 until mid-2017, performance was fine (see the blue line in chart one below against the equity income sector in green and FTSE 100 in red) and many large investors bought into the fund, backing Woodford’s strong reputation from the Invesco days, including the large platforms of Hargreaves Lansdown who put it on their Wealth 50 list of recommended funds. 


Chart 1: Woodford Equity Income fund against the equity income sector and FTSE 100

Over time, however, especially through 2017 into 2019, the expected returns from many of these investments did not come through. 1.png

  • Some of the issues at the investee companies such as AA, Provident Financial, Card Factory and Capita resulted in large losses that resulted in poor performance.  Because of the size of the fund and concentrated nature of the fund, Woodford held c. 20% stakes in several of these companies, effectively making them very difficult to sell.

 

  • In March 2018 the fund was excluded from the IA UK Equity Income sector for failing to have a sufficiently high dividend yield to qualify. 

 

  • The redemptions started coming in. From a peak AUM of £10bn, by early 2019 this was down to less than half the peak, this can be seen in Chart two.

 

  • With this level of sales, the key problem was that to fund the redemptions they could sell the quoted stocks but this correspondingly raised the proportion of the fund held in the unquoted stocks.  Because there is no ready market in which to sell the unquoted biotechnology stocks, the fund was repeatedly caught with having no option but to sell the quoted stocks which increased the proportion of the unquoted stocks even higher, ultimately above the 10% regulatory limit.

 

  • In March 2019 they tried to get around this by transferring some of the unquoted holdings to the Woodford Patient Capital fund and even tried to obtain quotes for the stocks in an obscure Guernsey stock market. 

 

  • As redemptions built, the Fund could not cope with requirements to divest of the unquoted holdings in particular but hedge funds were also beginning to short holdings in the quoted names too.  The attempt by Kent County Council to withdraw £263m on 3 June was the last straw.

 

Why doesn’t Equilibrium hold the fund?

We did. 

We originally put the Equity Income fund in Equilibrium portfolios in 2015.  Our portfolio analysis indicated that it was being managed in a similar nature to Neil Woodfood’s successful equity income fund at Invesco and held the prospect of the good returns of that fund.

However, the fund changed.  The key focus for our fund analysis is the underlying holdings, not whether they are Jupiter X, Schroders Y or Woodford Z.  The name is irrelevant and what matters is what is beneath the bonnet.

Here are a couple of snippets from our analysis in August 2017 on the Woodford Equity Income fund.

1. The table one shows the Woodford fund broken down into 3 main categories of shares over the calendar years.  Equity income funds traditionally hold ‘defensive’ stocks that have less sensitivity to economic growth which includes companies in the utility, tobacco and pharmaceutical sectors. 

Below you can see that the Equity Income fund held nearly 60% in these sectors when we bought into the fund in 2015. However, by 2017 this had changed very significantly.  The changes in the portfolio meant that it held over 60% of companies that were not defensive and, in fact, looked more like a ‘growth’ fund:-

Table 1: Woodford Categories of Shares

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Source: Morningstar

2.Drilling into the individual holdings we found that not only had the proportion of unquoted biotechnology shares risen but the quoted stocks had changed in nature.  In  table two you can see that the top 10 holdings of the Equity Income fund moved from being mostly defensive (orange) companies in 2015/6 to more risky and economically-sensitive stocks in 2017 in the left and centre columns:-

Table 2: Woodford individual holdings

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Source: Holdings from Woodfordfunds.com


For interest, we have also given the top 10 stocks held in the portfolio prior to suspension of trading in the far right-hand column – as you can see, the situation is even more extreme now.

We found this trend continued throughout the whole fund, not just in the top 10 holdings.

To us, the original investment proposition of a well-run, relatively low-risk equity income fund had changed to such a degree that there was only one option and it was sold in August 2017.  At that time, we switched into the Rathbone Income fund, a ‘traditional equity income’ fund. 

Since that time, the Rathbone Income fund has returned 4% whereas the Woodford fund has returned -25% - a variance of nearly 30%!

What happens now?

Just to set the record straight, there is no good news here. 

Link Asset Services, the fund’s authorised corporate director – the company that should be supervising the fund on the unitholders’ behalf - has suspended all trades and is obliged to review the situation every 28 days.  Indeed, it is required to do whatever it considers best for unit holders (including changing the fund manager).  Woodford is intending to sell down the unquoted stocks to zero. 

This is going to require investors to have patience whilst the situation is sorted out but is not going to happen quickly.  Fire sales of unquoted stocks often mean sharp discounts in valuations and so it is going to be a tightrope balance between speed of sales and avoiding loss of value.

At Equilibrium, just because we have no holdings will not mean we are complacent,  we will be improving our research processes to have greater focus on the liquidity of fund holdings and make our due diligence process even more granular. 

There are always lessons to be learnt.

 

The information provided in this blog is based on the opinion of Equilibrium Investment Management and represents a summary of recent developments. Our opinion is for general information purposes only and it is not and should not be construed as financial advice. It should not be regarded as a substitute for advice in any particular case.