In the Press… Neil Woodford and the Liquidity of Mutual Funds

Jonathan Ford, FT, Monday, June 10, 2019:

The collapse of the Equity Income Fund managed by the former stat stockpicker Neil Woodford illustrates again all the dangers of open-ended funds that promise instant liquidity while investing sometimes in hard to sell financial assets. In a fund penalized by large outflows, whatever the underlying reasons, remaining investors have a strong incentive to run since it becomes more and more difficult and costly for the fund manager to provide the expected liquidity. This kind of death spiral suffered by Neil Woodward’s fund is almost impossible to break.

In this interesting article, Jonathan Ford explains very well some fundamental reasons why the open-ended structure may be chosen despite its risks for the final investors (and the fund managers themselves in the worst crisis). There is a fundamental “market failure” based on most investors difficulty to assess this complex liquidity risk (mix of “asymmetric information” and “bounded rationality”). Due to the fees structure, financial intermediaries (platforms and fund managers) have some incentives to exploit the abnormal tolerance of retail investors for liquidity risks.

An interesting point which is not in this article is the heterogeneity of investors. All the investors in this fund were not naïve retail investors. Some of them were institutional investors who understood quite well the risks involved, but thought, probably rightly, that they would be able to run with no penalty if the situation was to turn nasty, leaving the bill to less sophisticated retail investors. It is therefore a fairly complex game in which some sophisticated investors are in a way complicit in profiting from less informed investors. Indeed, this sort of situation in which a flawed complex product continues to exist thanks to the implicit collusion between the producers and the most sophisticated clients is well known in the academic literature on “market failures” and consumer protection.

As Jonathan Ford concludes something has to be done to better protect retail investors. Obviously, the liquidity mismatch of the Equity Income Fund was quite extreme, but in times of economic and financial stress, this death spiral could potentially impact many mainstream funds invested in hard to sell assets (High yield bond, emerging markets assets, Coco bonds issued by banks, see this article).

Thus, what should be done? The Neil Woodward downfall may be “a canary in the coal mine” (see also this recent good FT article on the matter: Jenkins-FT-Woodford-undoing) and focus the regulators’ minds on this key topic. Current rules on mutual funds’ liquidity are clearly too general and not prescriptive enough.

Yet, this is a very complex issue because the solution is obviously not to condemn all open-ended funds and to go back to closed-end funds where the liquidity is only provided by the trading of the funds share in secondary markets. The liquidity provided by generous redemption rules in well-managed open-ended funds may be welfare enhancing.

In our view, the key issue is the question of how open-ended funds are valued when investors ask for the redemption of the shares they hold. We need well-calibrated exit fees that suppress the first mover advantage and the current incentives to run when a fund starts to suffer from large outflows. This was one of our central recommendations in our more general study of how financial markets and public authorities provide liquidity (see the following text for extracts dealing specifically with mutual funds).