For years, Neil Woodford was regarded as Britain's answer to Warren Buffett, an iconic fund manager who could be relied upon to beat the market. Now, his reputation lies in ruins, Woodford having suspended trading in his flagship fund as disgruntled investors queued up to get their money back after years of underperformance. Some commentators will pore over Woodford's errors, conclude that he lost his touch and look for a new stock-picking king to anoint. However, that would be to take the wrong lesson from this sorry episode.
Yes, Woodford made mistakes – many of them. He made his fortune as an old-fashioned value investor who bought defensive companies sporting big dividends only to stray outside his circle of competence in recent years, betting big on small-cap and illiquid companies and startups.
“Unless you believe you are the master of the universe, what makes a lifelong equity income investor believe they can spot early-stage technology companies?” asked one questioner in a video posted on Woodford’s website in 2017.
He was similarly hubristic in his attitude towards Brexit, insisting mainstream economists were wrong and that Britain would be not worse off by leaving.
Past performance no guide
Nevertheless, dwelling on Woodford’s individual errors is to miss the bigger point: past performance is not a guide to future returns, so investors should not have been surprised that Woodford failed to replicate his earlier success.
The simple reality is the vast majority of active fund managers underperform the market. Data from Spiva (Standard & Poors Indices Versus Active funds) shows that three-quarters of UK funds have underperformed their benchmarks over the last 10 years; the figures are even worse for US and global funds. In Europe, a majority of active managers outperformed in only three of 49 categories examined by Morningstar.
Some funds do outperform, of course, although they rarely continue to do so over the longer term. Only a very small minority of the top-performing quartile of funds over the 2007-12 period repeated their performance over the following five years, according to Spiva research; the top performers were in fact more likely to fall into the bottom quartile than maintain their elevated position. Rather than concluding that Woodford lost his touch, it may be his previous success was due to luck rather than skill. A study by Nobel economist Eugene Fama that analysed thousands of funds over a 22-year period concluded a tiny percentage of managers are skilled, but these top funds were "indistinguishable from the lucky bad funds". Alternatively, it may be that Woodford was a genuinely skilled manager but he lost his edge as markets evolved and became ever more efficient. Economist and Financial Times columnist Tim Harford gives the example of former Arsenal manager Arsene Wenger, who was hugely successful in his early years in English football only to be eclipsed by rival clubs in his later years.
“Mr Wenger’s emphasis on diet, data and the global transfer market was once unusual, but when his rivals noticed and began to follow suit, his edge disappeared,” says Harford. “In the investment world – and indeed, the business world more broadly – good ideas don’t work forever because the competition catches on.”
The same point was made two years ago by Robin Powell of the Evidence-Based Investor blog. "No one knows the relative contributions of luck and skill to Woodford's past success," said Powell. "But luck is not repeatable and, even if a fund manager has been skilful and profited from it in the past, there's no guarantee that he or she will be able to convert that skill into outperformance in the future." Similarly, no one knows whether things might have been different had Woodford stayed at Invesco, the fund giant he left in 2014 after 26 years at the firm. Did he miss the large team of supporting analysts and fund managers at Invesco? Were his riskier impulses reined in at Invesco, where he was answerable to company management and potentially faced more dissenting voices?
Woodford said he wanted to do “what large bureaucratic businesses can’t do” when he left Invesco to set up his own money management business in 2014, but perhaps the “bureaucratic stuff” he complained about would have prevented him from taking the outsized risks that have caused the current crisis?
Premature obituaries?
There is another possibility, namely that the obituaries are premature and that Woodford might, if given the chance, eventually turn things around. Certainly, it’s perfectly normal for even the very best fund managers to underperform over multiyear periods. One study of the top-performing funds over a 10-year period found an overwhelming majority – 81 per cent – experienced a three-year period of underperformance.
Anthony Bolton, the former fund manager who, like Woodford, was often compared to Warren Buffett during his long career, underperformed markets between 1989 and 2000, before eventually handsomely rewarding long-term investors. The irony is investors often give their money to investors like Woodford on the basis of their long-term record, only to then take a distinctly short-term approach; according to one State Street survey of institutional investors, almost 90 per cent said they would replace their manager after just two years of underperformance. Nevertheless, Woodford knows that is the reality of the investment business. In 2014, investors rushed to give him their money on the basis of his past performance; now, they're rushing for the exits for the exact same reason. And while such impatience can be unedifying, it's easy to see why investors in an active fund might get itchy feet. Passive investors who have their money in index funds know what they're meant to do during tough times: sit tight and hold on for the long term.
In contrast, it’s perfectly natural for active fund investors to wonder: has my manager lost his or her touch? Is this bad run due to permanent personnel changes at the company? How do I know the manager is not going through personal difficulties that are hampering his or her ability to do the job? Perhaps I should have heeded that line about past performance being no guide to future returns? Maybe they were lucky, not skillful? Maybe the strategies that worked in the past won’t work in the future? Has the fund become too big?
Simpler and cheaper
Investing in index-tracking funds is a simpler, cheaper and more evidence-based affair. Passive investing remains a minority sport in Ireland and the UK but not in the US, where the more sophisticated investing universe is increasingly dominated by index-tracking funds.
US investors long ago realised that very few managers beat the markets and that chasing performance is a low-probability bet. Painful as recent events have been for Woodford’s investors, the crisis is a valuable learning opportunity for investors on this side of the Atlantic, where the quaint cult of the superstar fund manager has persisted for far too long.
