The Brutal Story Behind a Liquidity Disaster

The UK financial sector was stunned when, on June 3, star stock-picker Neil Woodford blocked redemptions from his $4.7 billion (£3.7 billion) flagship LF Woodford Equity Income Fund following the departure of several key investors. 

The decision to suspend trading came after months of outflows that steadily depleted the fund’s value from a high of $12.9 billion (£10.2 billion) in May 2017. 

Yet somehow, the looming crisis had been overlooked. 

When it came, commenters called it “a bonfire of reputation” and “a mess of his own making.” Others, especially politicians, blamed the Financial Conduct Authority, the UK regulator, for not being alert to the problem.

In response, Andrew Bailey, the chief executive of the Financial Conduct Authority, suggested that the saga might have wider implications for investors in illiquid assets. Interest in illiquid assets has risen among European investors hunting for performance in an environment of low bond yields since the financial crisis. 

But the acceptance of these assets, including unlisted shares, high-yield bonds, loans and credit derivatives, poses a central problem to fund managers who must provide daily prices for a portfolio that cannot easily be liquidated.

“We should not discourage investment in illiquid assets,” Bailey said. “But we also need appropriate rules around investments in illiquid securities to protect investors.”

Regulators may only just be waking up to the scale of the problem. But the situation has existed for some time, according to Mark Northway, investment manager at Sparrows Capital and the chair of ShareSoc, a non-profit that represents individual investors. 

Northway notes that after the 2016 Brexit referendum in the UK, open-ended property funds managed by Standard Life, Columbia Threadneedle, Janus Henderson, M&G and Aviva had to suspend withdrawals after a run on liquidity. 

Woodford’s equity income fund was open-ended, meaning clients could demand their money back daily. Open-ended funds are required to limit their unlisted assets to 10 percent of their overall portfolio under UK rules. But Woodford put some of those unlisted assets in his funds into vehicles and then listed them in Guernsey.

Bailey, in his response, said: “Simply listing an unquoted company overseas does not in itself make the stock more liquid.” The FCA, which had planned new rules around open-ended investment funds after the suspensions that followed the Brexit vote, said it would take recent events at the Woodford fund into account.

One solution would be for a fund to restrict its liquidity terms to the liquidity terms of the assets held in the fund. Otherwise when a manager is required to sell assets to meet redemption requests, they will sell off the most liquid assets, leaving remaining investors holding what is left. 

“In any open-ended fund there needs to be a mechanism to ensure that fund liquidity and portfolio liquidity are kept in lockstep,” Northway says. He advises a move away from daily trading and the imposition of a notice period for withdrawals – plus increasing scrutiny on the way in which some fund managers circumvent the rules.

Woodford’s reputation came crashing down after some of his key investments, including the subprime lender Provident Financial and the construction group Kier, did not work out. But Northway and others also see his downfall as a failure of character.

“His self-belief made him blind to the liquidity risks he was running in his open-ended funds. He defended his strategy until it was too late to avoid the stampede,” Northway says. 

Northway is reminded of a certain figure in Greek mythology: “Daedalus warned Icarus of the dangers of complacency and of hubris. Like Icarus, Woodford has chosen to fly too close to the Sun with disastrous consequences.”