July 2019 IssueLong scroll reading

One Hand Clapping

By Edward A. Studzinski

“In wartime, truth is so precious that she should always be attended by a bodyguard of lies.” Winston S. Churchill to Josef Stalin, concerning plans for coordinated deception, at a party celebrating Churchill’s 69th birthday, 30 November 1943

The second quarter of the year has provided investors with a variety of results, as well as a variety of interesting stories. One of the greater debates has been about the value of individual, active investment managers versus the alternative of passive investing, relying on a low (or lower depending upon the firm) cost approach to equity investment. Subsumed within this debate has been the question of whether the day of value investing has passed, as a world of again declining interest rates and the anticipated return of central banks to quantitative easing permanently results in a world that favors growth over value.

In that vein, the Financial Times of London in the weekend issue of June 8/June 9 of this year ran a long piece on asset management concerning the travails and potential downfall of star UK stock picker Neil Woodford. The FT argued in sum that the risks of placing too much faith in the skills of a star stock picker were underestimated. At the same time, the arguments in favor of active fund managers were sometimes undercut by the often unconstrained and undisciplined antics of star managers.

In the UK, Woodford was accorded cult-like status because of his performance record, a Buffett for retail investors. That followed from a performance track record built up over twenty-six years at UK asset manager Invesco Perpetual. That record gave Mr. Woodford the confidence to depart Invesco Perpetual and set up his own firm some five years ago, Woodford Investment Management. With the perspective of hindsight, some would say that the seeds of the firm’s present difficulties were sown at the inception of the new business.

Initially, assets flowed in and the performance at the new Equity Income Fund beat its benchmark. But as the assets under management grew, Woodford found it necessary to look further afield for investment opportunities, taking stakes in small and midcap companies. This was a major investment philosophy change from what had garnered his reputation to begin with, which was out of favor, large cap blue chip companies.

Another problem was that in his own company there were fewer restraints (the better angels) upon Mr. Woodford’s investment decisions. At a large company like Invesco, there were many compliance rules and compliance personnel overseeing those rules. Not so at Woodford Investment Management according to the FT, where those raising objections to strategy or implementation found themselves ignored or exiled. As performance lagged, a familiar story to some of us took place, with financial advisors pulling client accounts and funds. This led to the selling of liquid investments to meet the redemptions. Over a short period of time, the illiquid investments in the Equity Income Fund reached a point of potentially breaching certain rules for illiquid investments. This ultimately led to a decision by the firm to bar redemptions.

“Never buy a fund named after someone. [You get a] total failure of risk control.” Sir Gerald Edgar Grimstone, chairman, Barclays Bank plc

There are a couple of lessons for investors from this situation, which is not unique to the UK. One industry insider, Mr. Gerry Grimstone, the former chairman of asset management firm Standard Life Aberdeen, made the generalization that one should never invest in a fund named after someone (such as the fund manager or managers). Grimstone indicated that the result is a total failure of risk control. The other lesson is to pay attention to the relationships that sometimes occur between asset managers and the platforms that distribute those funds. You can see that in this country where much of the ownership in funds is not direct, but rather when you review the prospectus, indirect through the distributor platforms such as Schwab, Fidelity, TD Ameritrade, et al. Make sure you understand what the incentives and inherent conflicts of interest there are between the investment managers and the distributors in terms of discounts, fees, and the like. As in equity trades, you must look to where are the real economics. Is it in the commission dollars or in the order flow? Finally, pay attention to the reputations of the fund managers involved (which is very difficult for outsiders to know). There are a lot of egos in money management. An asset gatherer may fall too much in love with the fees from a large star-manager managed fund to also pay close attention to the risk controls, often until it is too late.

The Unseen Hand

We now turn to the problems of H2O Asset Management in London, a subsidiary of Natixis Asset Management in Paris (which also owns Harris Associates in Chicago and Loomis Sayles in Boston). H20 Asset Management in its fixed income funds, according to articles in the Financial Times on June 25, 2019, had taken an outsized position in bonds tied to a German finance investor, Lars Windhurst. What prompted these stories was a report in FT Alphaville the previous week that H2O’s latest regulatory filings listed 1.4 billion Euros of investments in illiquid Windhorst bonds in six of the H2O funds.

This presents a familiar picture of a firm, H2O Asset Management, where strong performance and large inflows led to growth in assets undermanagement as well as profitability at the firm level that flowed up to the parent. Illiquidity in investments is not a problem in and of itself but can lead to problems when the position sizes increase as withdrawals from funds (with daily redemptions permitted) increase. This, as we saw with Woodford, often leads to the more liquid investments being sold to meet redemptions. The follow-on is that that often leads to increased concentrations of illiquid investments. And if you are running concentrated portfolios to begin with, the problems can be exacerbated.

As H2O clients continued to seek withdrawal of funds, they were told that they would have to accept a “haircut” of from three to seven percent on their redemption pricing, what the FT referred to as “swing pricing.” This ends up putting the burden of higher trading costs on the clients seeking their money rather than the investment firm itself and the parent.

One great driver of management behavior is the desire to keep assets high enough, long enough, to sustain the continued financial rewards at the firm and parent level.

What are the real issues here? The real issues come down to greed – of clients, investment managers, and asset gathering organizations and oversight – at the investment management firm level as well as at the parent. The structure of an investment in an investment management firm by an asset gatherer like Natixis generally leads to a quick payback of the initial purchase price of the business. What follows is basically an annuity stream of profits upwards. While the annuity stream of golden eggs continues unabated from the investment manager geese, oversight perhaps leans more towards the collegial side rather than adversarial. The danger of course comes when we are at a time of more than two standard deviation valuations in the markets, with investment managers often tempted to “reach” for performance (after all, it’s other peoples’ money). You want to keep the investors from redeeming, while keeping the asset levels high enough to sustain continued financial rewards at the firm and parent levels. Only time will tell whether the degree of oversight was adequate for the conflicts and contradictions inherent in the active management business model practiced by asset gathering firms in general.

This entry was posted in Edward on by .

About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.