The Perfect Fund Paradox
Did Neil Woodford, and his fund’s holders, get caught chasing the impossible dream of the perfect fund?
The news that Downing are to install two new dishwashers in our staff kitchen (scoop - you heard it here first!) reminded me of an article I wrote in my previous job.
It was about a killer rule of good product design: If you don’t consider your users’ weaknesses, their weaknesses will quickly become yours.
In my world - fund management in the UK - you could read this article as a reaction to the Woodford fund fiasco of 2019, in which panicking fund holders played a part in the fund’s collapse (poor performance caused some holders to sell, which then escalated until there was a run on the fund — see chart).
Only it wasn’t a reaction; I wrote it back in 2015, four years before the Woodford debacle, highlighting that this wasn’t something new or unpredictable: You should always know how hard it will be to get your money out of a financial product, particularly in times of stress.
Originally posted on Trustnet in August 2015:
My company has a problem. It’s a stubborn problem that has, so far, defied all attempts to fix it. In fact, it seems to be getting worse. Our problem, I’m ashamed to admit, is dirty dishes.
The population on the first floor of our office has recently expanded. So much so that the old kitchen had to be revamped. As anyone who has shared a kitchen will know; the usual pinch point is washing up.
To avoid a quagmire, it was our collective responsibility to keep the kitchen usable by filling or emptying a standard domestic dishwasher throughout the working day. While this had (mostly) worked in the past, it was clear that this machine wouldn’t be up to its expanded role. So it was, with regret, fired.
In its place came two new, commercial washers. Their advantage was clear: the wash cycle is only five minutes. So it was goodbye to that hour-long wait, during which plates and cups piled up in the sink. Now, we need wait just a few minutes before unloading the machine, thereby clearing it for use again. In this way, the kitchen remains satisfyingly clear all day.
The new machines are, in theory, perfect.
Only they’re not. As the great Yogi Berra once said, presumably after another failed picnic heist; “In theory there’s no difference between theory and practice. In practice there is.” And where this theory failed is that, while the new machines may be perfect, we, the users of the machines, are not.
Far from it, in fact. All it would have taken for the system to run smoothly was us — the users — learning a few simple operating rules.
Rules as simple as, for example, rinsing your plate first. Yet our frequent failure here has meant mugs being sluiced in what’s best described as a disappointingly under-seasoned minestrone.
If that rule is simple, then this one is Forrest-Gump grade: “don’t put soap in it”. For, as it turns out, pouring washing up liquid (washing up liquid! There isn’t even a place to put it!) into a commercial dishwasher is a sure-fire way to recreate an Ibiza foam party circa 1998, albeit without the music, whistles or class-A drugs.
There are many more issues to boot. All have resulted in the kitchen clogging up with dirty bowls, and all have been generated by our collective failure (and/or unwillingness) to learn how to use these simple new machines.
I mention this not as a gripe about colleagues (that’s what post-it notes are for), but because it reminds me of the fund world. I’ve spent much of my fund-picking career pursuing of the Perfect Fund, but have never found it. I now know, however, that the Perfect Fund doesn’t exist. It doesn’t exist because it can’t exist.
Why is this so?
It can’t exist because of us; the users. The Perfect Fund, in my book, would have a number of features. Among other things, it would be entirely unconstrained by benchmark, highly concentrated into the very best ideas and willing to hold niche, illiquid assets that could take years to pay off.
In theory, a fund run like this could be a world beater. In practice, however, it would be completely unusable.
Unusable because its stellar returns would, necessarily, be interrupted by long and severe periods of underperformance. Even if I (and that’s a big ‘if’) was prepared to stomach these, chances are that other users would not.
And if they do not, this Perfect Fund would be forced to close, most likely at an inconvenient and costly point in time. QED the Perfect Fund is not the perfect fund. It is a highly imperfect fund. The Perfect Fund, like the perfect dishwasher, is a paradox.
A paradox caused not by its design, but by the competence of its users.
Fund buyers need to understand this. In studying a candidate, we need to work out how susceptible it is to user error. That incredible run up it just had may be enticing, but we need to be sure not just whether we could stand it reversing, but whether its other holders could too.
Because even if we do stand firm, we may be left holding the baby if others cave in.
Likewise, product providers and fund managers also need to understand this paradox. I’m second to no-one in encouraging fund managers to step away from the benchmark. But they too need to be wary of taking their holders on too wild a ride, lest they render their fund unusable.
I get the sense that the industry is starting to pick up on this, but only just. It will wise up eventually though, particularly when it realises capital is flowing away from funds they think buyers should use, to those that buyers actually want to use.
2022 Epilogue
The Woodford collapse had far-reaching consequences for the fund industry, many of which are still playing out (for the avoidance of any doubt — I didn’t hold it).
Bizarrely, one of the big take-aways seems to be that investors should be wary of small funds, and stick to large funds instead. This is almost exactly the wrong lesson: Woodford Equity Income was over £10bn at peak. That’s not a small fund. That’s a large fund.
So, I mentioned simple instructions for using the dishwashers. Here’s one for funds: If you’re worried about getting your money out, beware of large funds that hold small, illiquid stocks. On this front at least, the opposite; small funds holding large, liquid stocks, are far safer bets.
