Funds – how big is too big?

Woodford is back in the news again, and with it talk of fund size and managing liquidity. These concepts are central to that particular catastrophe, so they’re clearly important things to understand.

However, there are plenty of common misunderstandings along with some misplaced beliefs that you can cover it all off with a single, catch-all rule. But in fund investing, as in life, things are more complex, and each situation must be assessed on its own merit.

But to attempt a simple answer, it’s useful to imagine being in a theatre when a fire breaks out. It’s useful because a lot of liquidity-risk controls are like health & safety assessments – they’re carried out in times of calm, when what really matters is what happens when everyone’s panicking.

So, in that theatre, there are plenty of variables that matter. But for the purposes of our metaphor, there are a few that really matter: How big is the theatre? How many exits are there? Are those exits clear or blocked? How big are those exits? How big are you compared to those exits? How many people are in the theatre with you? And how big are they?

To take one example, what if a fire breaks out in the middle of a small theatre? How likely are you to survive?

Hard to say, right? Because you don’t know the other details. If it’s just you and another couple of people in there (perhaps it’s the matinee performance of an impenetrable Danish play about the deeper meaning of consciousness) then, even if there’s only one exit, you’ll be able to mosey out of the building with no problems (provided you haven’t nodded off – a genuine risk in that scenario).

Likewise, if the theatre is small but this time it’s full, you could still be OK, as long as the theatre has plenty of easily accessible exits. Much then depends on whether you get trampled by a large, panicking man who’s steamrolling his way to safety.

Clearly, I could go on about theatre scenarios all day. But it’s more useful to talk explicitly about funds.

The biggest liquidity blow-up of recent years was Woodford. For our purposes, the key things to note were that this was a large, popular fund that held some deeply illiquid positions (they were unlisted stocks, so to sell them he needed to go out and find another buyer, he couldn’t just send them off to the market). The Woodford Equity Income fund was also held by many holders who didn’t understand fund investing, and in some cases they were huge (Kent County Council pension scheme take a bow).

In the Woodford case, the risks were so high that it didn’t even take a fire in the theatre. It was more like an usher having a cheeky smoke in the loo, and some of the holders caught a whiff of the smoke and got worried about a fire. So they left. Which caused more to leave which, eventually, spooked Kent County Council into making a mad dash for the fire exit. But, on account of its generous girth, it got itself jammed – trapping everyone behind it.

This is almost the exact opposite to the funds we hold at Downing Fox. We like small, unpopular funds that hold liquid securities. This is akin to being in a smaller theatre that’s nowhere near full, and has lots of big, clear exits. We also take time to understand who’s in there with us. Often we’re the biggest holder, which suits us – if there’s any steamrolling to be done, we’re the ones doing it.

We also hold plenty of funds spread across different global markets, which raises the number of exits our holders have if they want to leave in a rush (one of the many advantages funds of funds have over Model Portfolio Services (MPS) is that we can hold as many funds as we like, whereas MPSs tend to max out at about 20 before the administrative challenges become too much).

To be clear on the above, the funds we pick are not so much ‘unpopular’ as ‘not-yet-popular’. We believe our edge is finding newer funds that will perform so well that, in the future, they will become popular. Then, should we judge that they’ve become too popular, we will collect our coats and calmly head for the exit.

Simon Evan-Cook, Manager of the MGTS Downing Fox multi-asset range.

Photo by Rohan Makhecha on Unsplash