Once upon a time, Neil Woodford was the most celebrated fund manager in the UK. Today, Woodford bashing has almost become a national sport.
So what mistakes did he make and, more importantly, what can we learn from the great man’s downfall?
[Warning: This article may contain irony]
Mistake #1 – Not hugging the benchmark
Woodford’s first mistake was to not hug his benchmark (i.e. the market index) closely enough.
His portfolio was consistently weighted towards sectors and stocks which he thought offered the best value, rather than those that were heavily weighted by the market.
Neil should have known better, because every sensible investor knows that the best way to avoid underperforming the market is to make your portfolio as similar to the market as possible.
If you do that then you cannot be criticised when your portfolio performs badly. You can simply point to the equally weak market performance and say “it’s a bad market for everybody”.
Of course, doing exactly what the market does rules out the possibility of outperforming the market, but that’s a minor inconvenience if your main priority is to avoid criticism.
The lesson here is obvious:
If you want to avoid occasional bouts of underperformance and criticism then give up trying to beat the market and just copy it instead.
Mistake #2 – Making high conviction investments
This mistake is closely related to mistake #1.
Clearly, if you want to avoid criticism when an investment goes off the rails then you should have no more than two or three percent of your portfolio in any one company.
That way, if something does go wrong with a particular company it won’t make much difference to your portfolio.
You’ll be able to inform everyone that problems with that one holding don’t matter because you’re “well diversified”.
That may be true, but having tiny amounts invested in each company means that your portfolio will need to invest in more companies, and at some point it will begin to resemble the market.
So the chances of outperformance will go down, but then again so will the chances of underperformance and criticism.
Neil should definitely take note of this lesson:
If you want to avoid occasional bouts of underperformance and criticism then don’t make big bets. Don’t put more than 2% into any one company and don’t invest heavily in companies you think are attractively valued.
Mistake #3 – Giving the impression that excellent returns were inevitable
This is perhaps Woodford’s biggest mistake.
If you are consistently rubbish as an investor then nobody will bat an eyelid if you underperform because it happens so often.
But if you have the audacity to beat the market by about 5% per year, on average, from 1990 to 2015, as Woodford did, then you should know better than to expect an easy ride when things go wrong.
One way to avoid consistently beating the market is to track the market, but we’ve already covered that route to the quiet life.
Another approach is to make sure you always beat the market and never ever underperform. Of course this is impossible, unless you do a Madoff and run a ponzi scheme.
If you do that you can beat the market every single year for decades, at least until the whole scheme collapses and everybody is left penniless.
With that in mind, my final lesson for Neil and other investors is this:
If want to avoid criticism when you underperform then either:
- Only ever outperform the market by a small amount for a short while, so that when you do underperform nobody can be bothered to criticise you, or
- Do a Madoff and run a ponzi scheme so that you are guaranteed to outperform the market every single year, forever (or at least until the scheme collapses and everyone is left penniless).
The problem is (probably) not Neil Woodford
Hopefully it’s obvious that my list of Woodford’s “mistakes” are tongue-in-cheek and that they are in fact exactly what you should expect to see from a well-run actively managed portfolio.
I’ll rephrase each “mistake” in a more positive light:
Positive feature #1 – Having a portfolio which is very different to the market index.
Any differences will inevitably lead to periods of underperformance, but those differences are absolutely required if you want better returns than a passive index tracker.
Positive feature #2 – Have some investments which make up a significant portion of the portfolio.
2% or so invested in 50 or more companies is a very low risk way to invest, but I think it’s much harder for that sort of approach to beat the market (and if it isn’t going to beat the market, why bother?)
There are limits to this line of thinking of course, and I’m not saying that 50% invested in one company is a sensible approach.
For example, in my portfolio I trim back any holding which exceeds 6% of the total.
Woodford seems to be comfortable with a maximum of around 10% invested in any one company, but much more than that is probably too much for most people.
Positive feature #3 – Having a long track record of relatively consistent outperformance, with occasional periods of underperformance.
As an active investor you simply must get used to the idea that occasional bouts of underperformance are inevitable if you’re trying to beat the market.
If you cannot stomach even short periods of underperformance then you should probably stick to index trackers.
But if you can accept short periods of underperformance with stoic calm, then you may just succeed as an active investor.
And by “short periods” I mean anything up to a few years.
That’s longer than most people’s definition of “short periods”, but underperformance over anything less than five years is simply not relevant.
Over that sort of timescale, changes in share prices and fund values are driven not by the true, fundamental and intrinsic value of the investment, but by the fickle nature of other stock market investors.
So if your portfolio of shares or funds underperforms over a week, a month or even two or three years, there may not be any problem at all.
But if your portfolio underperforms over five or ten years then yes, perhaps it’s time to ask the portfolio manager (whether that’s Woodford, another fund manager or yourself) if they know what they’re doing.
Has Neil Woodford lost it? It’s too early to tell
As for Woodford, I have no opinion on whether he’s “lost it” or not because his period of underperformance is so short.
I think the sensible thing to do would be to wait a few years and then see how he’s performed over the previous five years.
If he’s still underperforming by that point then yes, perhaps he has lost it.
A healthy response to criticism
To be fair to Neil, I’m sure he’s been asked whether or not he’s “lost it” about a million times in the last few months.
I’m also pretty sure he’s sick of it.
He certainly looks a bit fed up with the whole thing in this admirably candid and slightly funny video, which I think is a pretty good way to respond to all the recent criticism (although he does occasionally looks as if he’s going to punch someone):
To sum the whole thing up, here are a few wise words from the Woodford website:
Equity markets take a random walk on a daily basis. The forces of fundamentals and valuation may be over-ridden by sentiment and the whim of the market in the short term, but it is the longer time periods that count. We look beyond the short-term noise and focus on the long-term drivers of share prices.
Disclosure: I don’t own any of the Woodford funds, but I do think his value-based approach makes a lot of sense, although my strategy is quite different to his.