You can't trust the experts to pick winners
It’s one thing for ordinary individual investors to fall into the trap that good past performance makes it look like a fund manager has got star quality. Private investors’ long-time favourite Neil Woodford, Britain’s answer to Warren Buffet, has well and truly sprung that trap. His Woodford Equity Income Fund is ‘gated’: closed to redemptions until further notice after investors fled in droves following a long period of substantial underperformance. But why did so many well-resourced and reputed professional fund selectors, including integrated wealth manager St James’s Place, restricted adviser network Openwork and retail platform Hargreaves Lansdown, fall into the same trap?
As manager of Invesco Perpetual’s High Income Fund until he left to start his own fund management company in 2013, Neil Woodford was one of the few managers who had earlier passed our purely quantitative tests for generating plausible ‘alpha’, or risk-adjusted returns in excess of a benchmark. But it was because so few did, and in some countries none, that we decided there was no point including any active funds in our portfolios, even though we could see value in the ‘alpha option’: being in with a chance of outperforming. But he put us off in another way. Though the statistical tests suggested it was unlikely he achieved his results simply be getting lucky, when we applied analytical judgement to the data history we reached an entirely different conclusion. This was not plausible alpha: this was an exceptionally long period of a single strategy paying off. That is not something that happens often or that active managers can bank on. It's a lucky break, even if it takes some skill to exploit it.
We wrote this up in October 2013 when he announced he was leaving to start his own firm, presenting his investors with the problem of deciding whether to follow him, stay with the rest of the team at Invesco or simply say ‘thanks and goodbye’ until he proved his worth again. ‘Well before the bombshell’, we said, ‘questions were being asked about whether Woodford had lost his touch, even though the recent performance had only been mediocre. Such is the problem of following a star whose reputation, though long-lived, was based on alpha generation between 6 and 14 years before (or even the original episode 20 years ago).’
Those investors who chose to follow Woodford into the new Woodford Equity Income Fund were rewarded with about 18 months of outperformance before what turned out to be a peak. Unfortunately, the peak coincided with the launch of a second income fund family. And judging by the path of funds under management, many who ended up backing him in either fund only did so after that initial good period, treating it as the ‘proof’ they were looking for. Now they are nursing not just relative but absolute losses.
Woodford’s first real test was always going to be what to do when the strategy of (relatively) long utilities and tobacco and short banks (described more fully in our 2013 post) finally needed to be changed. The shorter the period of payoff to a winning bet or strategy, and the more frequent the changes in bets, the greater the number of tests and the more likely that passing the tests is a sign of skill. When he came to change it, what he chose proved to be either the wrong strategy or, by a some distance, the wrong timing. Two big bets: one right, one wrong. Compare this with Warren Buffett who over his career has radically changed his entire investment approach, let alone the bets, many times, adapting chameleon-like to the changes in the market dynamics.
Maybe all the professional fund selectors, including highly-successful businesses like St James’s Place and Hargreaves Lansdown, who have been shamed by the collapse of confidence in Woodford Investment Management, were no different from self-directed investors: they saw only what they wanted to see. Worse, maybe it was all about their own business agenda, having little or nothing to do with investors' best interests. Whichever, their embarrassment will only serve to hasten the switch from active to passive, as people realise that you can’t even trust the experts to pick winners.