What lessons in liquidity management can the Neil Woodford saga teach investors and financial regulators?

Neil Woodford

In the second of a two-part blog, MATTHEW FEARGRIEVE explains the regulatory response to the liquidity management issues thrown up by the catastrophic mismanagement of The Woodford Equity Income Fund, and asks what lessons can be learned by investors and regulators alike.

Previously, we considered Neil Woodford’s breaches of the UCITS liquidity rules and how the illegally-illiquid portfolio of The Woodford Equity Income Fund (“WEIF”) could not be realized in time to meet the wave of redemption requests being made by spooked investors. A fire-sale of the fund’s liquid (and better quality) assets ensued, and in desperation Woodford suspended redemptions in WEIF; in so doing, he locked his investors into a tanking and ultimately doomed fund. At time of writing (March 2020), about a fifth of WEIF’s peak net asset value of GBP10 billion has been realized by the fund’s liquidator. You can catch up on this and more in the first part of our blog, here:

UCITS = daily liquidity

WEIF was structured as an Undertaking for the Collective Investment in Transferable Securities (UCITS). The genesis of UCITS, two decades ago in the regulatory framework of EU law, was as a liquid investment product, highly regulated and regarded as “safe” for investment by ordinary, unsophisticated, retail investors. But for more than a decade the UCITS envelope has been pushed by EU states and regulators competing with each other for business. Under UCITs rules, illiquid investments should have a very small and restricted place in the fund’s portfolio. But increasingly, financial regulators in Luxembourg have permitted the shoehorning of illiquid assets into UCITS.

One positive outcome of the Woodford saga would be a wholesale revision by regulators, including the FCA in the UK, of the UCITS rules. Followed by a revamping of the resources and infrastructure at the regulators’ disposal to effectively police manages. As amply demonstrated by Woodford, the things that some managers are being allowed to get away with have the potential materially to shift the position on any objective risk spectrum of what is meant to be a safe and well-regulated retail investment product. And it will always be retail investors, their savings and their pension monies, that pay the price.

Non-UCITS = flexible liquidity

Some commentary in the immediate aftermath of the closure of WEIF has asked whether the daily liquidity posited by the UCITS model should be subjected to some sort of qualification.

A solution may be found in the non-UCITS (NURS) regime. These illiquid or semi-liquid investment funds have traditionally mainly been used for real estate portfolios, but the regulatory framework is capable of revision and expansion to accommodate investors with the appetite and risk tolerance for some — intentional — illiquidity in a fund’s portfolio, and who understands the liquidity profile of his shares, which may be redeemable monthly or quarterly, as opposed to daily.

The NURS model — had it been sufficiently evolved in this regard from the version that was available to Neil Woodford back in 2014 — would have been better suited to his investment style than the “liquid” UCITS that WEIF ended up being. You can read more about NURS and the regulatory failings that the Woodford saga exposes in our previous blog here:

Non-UCITS: Regulatory Response

By September 2019, redemptions in WEIF had been suspended for some two months. It was, coincidentally perhaps, at this time that the FCA announced new rules requiring NURS invested in illiquid assets to suspend dealing where an independent valuer determines there is “material uncertainty” regarding the value of more than 20% of the fund’s assets. The new rules also require managers of NURS to formulate and keep updated a plan to ensure that liquidity risk is actively kept under review.

Additionally, the FCA rules will require managers of NURS to provide investors with clear information on liquidity risks, and the circumstances in which their ability to redeem their investment may be restricted. The rules, which will come into force in September 2020, are designed to reduce the likelihood of investors rushing en masse to the exit, leading to a fire-sale of assets which is profoundly damaging for investors left behind in the fund, as was painfully the case with WEIF.

UCITS: Regulatory Response

In June 2019, whilst WEIF was suspended, Mark Carney, then Governor of the Bank of England, said that funds which purport to be liquid, but which are invested in illiquid assets, are “built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid. And that leads to an expectation of individuals that it’s not that different to having money in a bank”. He went on to opine that liquidity mismatches in high-value investment funds could pose a systemic risk, in a clear reference to WEIF.

Mark Carney said that liquid funds invested in illiquid assets are “built on a lie”

This comment from one of the most senior financial officials in the UK was both timely and spot-on.

The EU’s federal financial regulator, the European Securities and Markets Authority (ESMA) has announced that it will lead a common supervisory action on liquidity management in UCITS. This is intended to help ensure consistent application of EU rules on liquidity management and ultimately enhance the protection of investors across the EU. In addition, ESMA will publish liquidity management guidelines (expected September 2020) which will require managers to subject their funds’ assets and liabilities to stress tests in given operational scenarios, notably redemption requests by investors which, ESMA believes, is the most significant source of liquidity risk facing investment funds.

In the UK in March 2020, with the remaining available funds in WEIF still not paid out to Woodford’s investors, the FCA has signalled (after receiving a degree of post-Woodford criticism from the press and the UK’s financial services industry) a more proactive approach to policing managers. The FCA emphasizes the importance of effective liquidity management and states that, where the regulator identifies potential liquidity issues, it will ensure that managers take prompt action to mitigate or resolve them. The FCA has indicated that it will be liaising with depositaries (the custodians of the fund’s portfolio assets) to help monitor such liquidity issues.

Liquidity Management Lessons

So European financial regulators appear to be in the process of taking on board at least some of the lessons that can be learned in the wake of the Woodford scandal. What of investors, particularly the most vulnerable, the retail investors whose “daily liquidity” the UCITS model is supposed to protect? It goes without saying that retail investors should be entitled to receive a degree of protection from both their national regulator and the regulator of the fund’s place of domicile.

But what WEIF shows quite plainly is that, in the real world, retail investors must take their own chances. WEIF was aggressively sold- even when it was in suspension- by middlemen (notably Hargreaves Lansdown) to small investors, the majority of which would not have read the fund’s prospectus, probably reading at most the key information sheet provided by an intermediary. Retail investors (and, indeed institutional investors, like Kent County Council who found itself locked in WEIF) must understand the reality of “daily liquidity” when a UCITS fund is invested in illiquid positions; which in turn means that they must carefully read the fund’s prospectus and inform themselves about the manager’s investment style and strategy, and the regulatory limitations on its ability to depart from it and make illiquid investments.

Ultimately though, all investors, especially those in the retail demographic, deserve and need better protection from financial regulators against irresponsible, hubristic and reckless fund managers.