Liquidity and avoiding the pitfalls of the Woodford Equity Income fund

The headlines surrounding the suspension of the Woodford Equity Income fund and its eponymous manager are a timely reminder that there are no certainties in the business of investing. However, there are plenty of ways investors can mitigate their exposure to loss. The first rule is to ensure you are well diversified. The second rule is to ensure you have sufficient liquidity.

As qualified financial advisers know, putting your faith in only one particular fund or individual fund manager is a dangerous strategy and it’s my guess that a great many of the investors who have found themselves over-exposed to the drop and suspension of the Woodford Equity Income fund have been those who have chosen to shun professional advice and follow those the media have anointed ‘star managers’. That said, the fund has been well favoured by some investment specialists too…but not at PortfolioMetrix.

When constructing our own portfolios, the team here take a good look under the bonnet of all funds before we decide to include them. When we looked at this particular fund, we decided not to put holdings in it. Why? One word – liquidity.

We take liquidity very seriously and will not invest in funds where there is a substantial liquidity mismatch between the fund (daily dealing) and the underlying direct exposure. This is because during periods of stress the fund may have to fire-sell assets to meet redemptions, or, possibly worse, not meet redemptions. Both of which are unacceptable outcomes for investors.

For example, this is why we do not invest in direct property funds, instead we invest in those that buy and sell property securities (e.g. Real Estate Investment Trusts – REITs) which are much more liquid. This liquidity mismatch issue was already highlighted in June 2016 shortly after the referendum result where property values fell and a large number of direct property funds stopped trading.

For the same reason, we would also not invest in funds which have a large number of unquoted investments.

We do have holdings of funds that have exposure to smaller sized companies, but we are acutely aware of the liquidity risk involved with these stocks and thus the funds. As such, when we invest in funds with holdings of smaller companies, we appropriately scale the position such that exposure in portfolios is limited and overall liquidity is maintained.

A blog post by Nic Spicer & Phil Wellington