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There’s a price to pay for using an open-ended fund

Tom Stevenson

Tom Stevenson - Investment Director

This article first appeared in the Telegraph

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Neil Woodford, Britain’s best-known fund manager, has come in for a fair bit of criticism recently. Some of it is justified; some of it is just Schadenfreude. It can’t be much fun to be pilloried after years of adulation, but it goes with the territory. My former colleague Anthony Bolton suffered the same treatment when he brought a successful career to a close with an initially unrewarding period investing in China. Unfortunately, we love nothing better than to see our heroes fall back to earth with a bump.

The general criticism of Woodford relates to his investment performance. For someone with such a stellar track record, he has made a surprising number of poor investment decisions. The more specific criticisms have focused on his investments in unquoted stocks. First, he has been taken to task for investing in small non-dividend-paying businesses in an equity income fund which, as its name suggests, is principally designed to pay investors a high and sustainable income. Second, he has been caught out by fund outflows, which have resulted in his holdings of illiquid investments breaching regulatory limits.

The income gripe is reasonable but would not have been made if Woodford had not fallen short on the other two criteria. No-one looks very hard at a long tail of investments in a fund if it is meeting its primary growth and income objectives and not breaking the rules. Bad investment choices, too, can be overlooked in the short-term. Everyone knows that even the best investors have bad runs. His big mistake has been his failure to manage the liquidity of his equity income fund. And the principal cause of this was his decision to use an open-ended fund to invest in unquoted companies.

The attraction of this type of fund (what used to be known as a unit trust, now more commonly an OEIC) is its flexibility. You can put your money to work and take it back again at a day’s notice. Unsurprisingly, there is a price to pay for this freedom. It is the fact that open-ended funds are really suitable only for investing in securities for which there is a ready supply of willing buyers and sellers.

As we found out in the summer of 2016, open-ended funds are a bad vehicle for investing in commercial property because you can’t sell a small bit of a building. And, as Woodford has found, they are also ill-suited to investing in unquoted shares.

I had an interesting conversation recently with another well-known fund manager who has made a much better fist of shifting his focus to unquoted investments. James Anderson, the manager of the popular Scottish Mortgage investment trust, made a decision a few years ago to significantly increase his holdings of unlisted investments and you won’t find anyone with a bad word to say about his approach. The principal difference between Anderson and Woodford is that the former has chosen the right vehicle for the kind of long-term investment approach the unquoted arena demands.

Unlike open-ended funds, investment trusts are ideally suited to investing in illiquid assets. That’s because the money they manage cannot be redeemed on demand. As an investor you can sell your shares in the trust to another investor, but you can’t ask for your investment back. This is a huge advantage for a fund manager because they can make long-term bets and wait patiently for their investments to bear fruit.

The irony is that both managers are attempting to do the right thing for their investors. As Anderson told me, capital markets are no longer much good at providing the kind of permanent risk capital needed by the fast-growing businesses that we all want to invest in. That’s because, as investors, we want two incompatible things: capital preservation, a smooth ride and an income on the one hand; and access to tomorrow’s Amazons, Alibabas and Alphabets on the other. You can have both but probably not at the same time and in the same investment.

The truth that both Anderson and Woodford have identified is that the balance of value creation has shifted from the post-to the pre-IPO period in many companies’ development. There are many reasons for this. Two of the most important are that: first, companies are less capital-intensive than they used to be so they can afford to wait longer to raise money and are already big and established by the time they float; second, that companies are increasingly disinclined to face the kind of quarterly scrutiny suffered by public companies as they make the long-term investments that unavoidably burn through cash and deliver losses in the short term.

The reason Anderson has been given the right to invest up to a quarter of Scottish Mortgage in unquoted companies is that this is the best way to capture this pre-IPO value creation. Investing early in Chinese e-commerce group Alibaba is one example of this at work. But there are many others, including Airbnb and fintech darling Ant Financial (which was actually spun out of Alibaba). Getting in early is one benefit but it is not the only one. Gaining insights into disruptive industries from those at the sharp end is another. As Anderson says, the more interesting question is not why he is investing in unquoted companies but why others are not.

For personal investors the ability of the likes of Woodford and Anderson to extend their reach to unlisted shares represents a fantastic opportunity. They have the access that the rest of us can only dream of and they can put together an early stage portfolio at a more sensible cost than traditional venture capital investors seem to be able to offer.

The final irony of Woodford’s fall from grace is that he had already created the right vehicle for his unquoted investments. The Patient Capital investment trust was always the perfect home for the patient investments. Simple really.

More on Scottish Mortgage investment trust

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