The City watchdog’s failure to act on Woodford fund failed investors

The Woodford fiasco demonstrates that the Financial Conduct Authority, not for the first time, is failing in its duty to protect savers and investors, writes Andrew Pitts.

In early March of this year, when Money Observer first highlighted the worrying issues that would ultimately lead to disaster for investors in LF Woodford Equity Income fund, we listed several reasons for concern, beyond the fund’s (WEIF’s) very poor performance.

- Woodford Patient Capital: bargain or falling knife?

Lots of warning signs

The first warning that all was not well was WEIF’s shrinking size, when viewed in the context of the illiquid early-stage and unquoted companies it held. We asked “whether a 28% exposure to unquoted and early-stage growth companies in an income fund is what retail investors expect”.

The second concern questioned the transfer of assets in the income fund to its sister investment trust Woodford Patient Capital* (WPCT) and whether it represented a good deal for either party. For fundholders, the issue of new shares in WPCT at net asset value (NAV) represented an immediate paper loss on the fund’s new holding in the trust, because existing WPCT shares were trading at a 13% discount to NAV. Meanwhile, holders of the trust had to weigh up whether a near doubling of the portfolio’s exposure to five key companies as a result of the asset transfer (to 14.1%) was a sensible move.

We also highlighted the high correlation of unquoted and early-stage growth companies in the portfolios of both fund and trust, and suggested in addition that the discount on the trust was more likely to widen further than to narrow. That, unfortunately, has now transpired, with the discount on WPCT shares currently standing at 33% to NAV.

But this, too, could be something of a moving target – the trust’s unquoted holdings are valued by Link Fund Solutions (at least half-yearly and apparently with additional external oversight), but such valuations can either be ‘conservative’ or more forward-looking and therefore more ‘optimistic’.

Link is also WEIF’s authorised corporate director, or ACD. Its reputation has taken a pasting, not only for its failure to rein in Woodford – part of an ACD’s duty to protect investors in the fund – but also for facilitating the listing of several of WEIF’s unquoted stocks in Guernsey. This was essentially a ruse to get around the 10% limit on unquoted stocks that can be held in open-ended funds.

Andrew Bailey, chief executive of the Financial Conduct Authority (FCA), has admitted that WEIF’s ultimately unsuccessful attempt to list some of its unquoted companies in Guernsey was permissible under FCA rules, but said in June “I don’t think it is right”.

Woodford fund suspended until December

Stark facts in plain sight

Back in March, we concluded: “The stark fact of the matter is that WEIF’s exposure to such [unlisted and early-stage growth] companies was, in aggregate, far more appropriate to an income fund which had more than £10 billion in assets barely 18 months ago, than to one that has shrunk to £4.8 billion.”

Our parting shot was, admittedly, a thinly veiled criticism of WEIF’s continued presence on the Hargreaves Lansdown (HL) Wealth 50 list. “I would not be surprised if that asset mix is already worrying financial advisers with clients whose UK equity income diet should be served in one predominant flavour – plain vanilla. The same concerns might also be exercising certain retail investment platforms that continue to push LF Woodford Equity Income to clients on the grounds that they still have faith in the strategy, or that clients won’t find a cheaper version elsewhere.”

Some investors shared those concerns, because despite its continued presence on the Wealth 50, WEIF shed a further quarter of its value in less than two months before it was suspended.

WEIF’s inclusion on the Wealth 50 list until the day it was suspended has prompted the FCA to launch yet another inquiry into how best buy lists are constructed and whether they are impartial and thorough. Will Hargreaves Lansdown be in line for ‘six of the best’ for continuing to recommend WEIF on the Wealth 50, despite the warning lights that it admits were flashing as early as November 2017?

The FCA’s conclusions, when they come, will do nothing to assuage more than 130,000 HL clients who face an indeterminate period – possibly until the end of the year or longer – before they can access what remains of their collective £1 billion stake in the fund, which was last valued as having assets of £3.5 billion.

The equity income fund went seriously off-piste and Link, the fund’s ACD, failed to act. Hargreaves Lansdown, the major conduit of investors’ cash into the fund, had been aware that all was not well. It too failed to act by not removing the fund from the Wealth 50.

Blame for the Woodford saga, however, which is yet another stain on the reputation of the financial services industry, ultimately lies with the FCA. It should have moved on information it had previously received from Link and reports in the media about WEIF.

Woodford suspension illuminates investment trust advantage

FCA is in the dock

Its inaction follows hard on the heels of its failure to do anything about London Capital & Financial, which collapsed in January owing 11,000 investors £236 million. LC&F was an FCA-regulated firm punting unregulated ‘mini-bonds’ masquerading as fixed-term Isas, paying annual interest of 6.5-8%. As with Woodford, the FCA had been made aware that all was not well with LC&F. It is belatedly probing the firm’s collapse but is also facing calls to investigate its own conduct before LC&F went under.

Bailey’s comments with regards to WEIF’s Guernsey stock listings suggest that the inquiry it has launched into the fund’s suspension will likely focus on how Woodford Investment Management and Link breached the spirit, but not the letter, of the law. I expect the FCA will say that any breaches of its ‘rule book’ were not clearly evident.

Whatever the outcome, little consolation (or compensation) awaits investors in WEIF. Clients who invested in LC&F’s mini-bonds are expected to receive less than 20% of their investment back.

Not for the first time, the FCA’s failure to act failed to protect investors. When will it step up to the plate and replace its favoured ‘light touch’ regulation with something more heavy-hitting?

US equity cheer ringing hollow

Investors cheered as the US S&P 500 index marched past the 3000 level on 10 July, but the recent strong performance of risk-free government bonds also needs to be factored into forecasts for equities.

In February, when the S&P 500 index was trading around 2600, or 15% lower than it is now, I wrote that “there could be more juice to be squeezed from the US, given that markets tend to react to recessionary indicators more than to fears that the market is overvalued”.

We have been witness to a perverse situation where equity investors have reacted to the US Federal Reserve’s U-turn on interest rate guidance, pushing stocks higher, while bond market investors have pushed yields on the benchmark 10-year Treasury bond lower, sending bond prices higher as well. Diversified investors have never had it so good.

To illustrate, the 10-year US Treasury bond yield rose above 3.2% in November; in early July it dipped below 2%. That might not seem like much of a difference to you and me, but in bond market terms it’s a massive move.

Real returns by asset class

A graph showing real returns by equity class

Source: Capital Economics, 3 July 2019

Today, however, I think the US market really is looking overvalued because recessionary indicators are flashing red. Second-half profit expectations from the US titans are looking pretty soggy; big investment bank forecasters are becoming increasingly polarised in the bear/bull corners; and the market has been persistently trading at price/earnings multiples that history suggests spell danger.

Consultancy Capital Economics expects the second half of the year to be grim, with the S&P 500 index sliding to 2500 (20% below its current level) as earnings disappoint against a faltering economic backdrop.

However, one reason why joy may continue unbounded is the sheer amount of money sloshing about. That can be seen in the war chests of private equity investors. Data provider Preqin reckons these investors are sitting on a cash pile of nearly $2.5 trillion – and it is looking for a home, whether in real estate, infrastructure or equities.

That could provide further support for stockmarkets: stiff competition between private equity practitioners to put cash to work could see more publicly listed stocks taken private.

More for them and less for us? Almost certainly. But perhaps Neil Woodford might be able to persuade those controlling a fraction of that $2.5 trillion to relieve the suspended equity income fund of its unquoted holdings at a half-decent price. Any takers?

The author was editor of Money Observer from 1998 to 2015.

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