The broken buy list market behind fund due diligence

Buy lists advisers use for fund due diligence are part of an unaccountable system that needs overhauling

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Jul 18, 2019

I’m not certain many researchers and fund selectors had posters of Neil Woodford Blu-tacked to their bedroom ceilings but certainly, until fairly recently, a sycophantic hero-worship has characterised comment about the stockpicker. Over the years since the millennium, the rapture displayed when some journalists and advisers met Woodford was often akin to that of a gaggle of pre-teens finding themselves in a lift with Justin Bieber.

The suspension of the Equity Income fund has enabled financial pundits to mount a media pulpit and opine about the woes visited on unsuspecting investors by footloose fund managers.

The press has to reflect on its role in this debacle. Fund recommendations carried in the weekend financial sections of national press over the years were conveniently forgotten as the Woodford carcass was torn apart in June. I have been asked numerous times for comment, often only to have positive comment ignored. One reporter at a Sunday title listened to my explanation of the liquidity issue only to interrupt with “What my editor wants is evidence of fraudulent activity.” To coin a former Sunday rag’s hackneyed phrase, I made my excuses and left.

I understand why the press wants a fraud story. I can see why disciples of passive investing may point to this event as evidence that satanic forces are at work in the ranks of active management. I can comprehend the schadenfreude the event caused other managers. I’m even prepared to grant absolution to advisers who continued to recommend the fund through its astonishing fall from grace, underperforming its sector peers and the index by almost 8 per cent a year since the beginning of 2016. However, there is one group on whom I expect rather more of a spotlight to be focused.

Advisers in the habit of selecting funds rely on a cohort of experts who have claimed responsibility for performing due diligence on fund managers. Note the word ‘responsibility’, and not ‘accountability’. These gatekeepers have for the most part been able to pass judgement on fund managers’ future performance expectations based almost entirely on past performance, and without fear of challenge, or ex-ante checks on the subsequent efficacy of their ratings.

Gatekeepers Report

As long ago as 2016, the Gatekeepers Report, compiled by my business and Fundscape, noted that self-styled and largely unregulated experts awarded funds badges of excellence that allowed managers to promote themselves. Almost without exception, those research companies’ business models rely on fund managers paying for the privilege of using those badges in marketing material. No badge means no fee.

We noted the opportunity for bias, subconscious or otherwise. Since the manager pays the fee, these researched ‘buy lists’ are distributed to advisers, whose research budgets are minimal if not absent. In a form of quasi-meta-analysis, the researchers’ various badges are aggregated by those advisers as a proxy for their own due diligence.

When researchers recognise the importance of their lists, which are generally freely available via platform providers, they realise their influence can break a fund too. There is a behavioural asymmetry about this – when a fund is doing badly and you drop the rating, the manager doesn’t pay. Excusing poor performance must be tempting – “Neil’s faced tough times before, so we’re happy to stick with him.” And presumably happy to stick with the fee.

However, it’s not just independent researchers who publish lists. Direct-to-consumer platforms and other distributors create fund shortlists too. These are intended to help investors make investment decisions. While no fees are involved, the mere fact the list is deemed to reflect the expertise of internal researchers must be construed by investors as guidance if not advice.

Other than a weak reference to impartiality and timely updates, the FCA has been conspicuous by its absence on the subject of regulating fund research

Despite unquoted holdings extending and exposure to bombed-out stocks rising in 2016-17, a clear shift took place in the risk profile of the Woodford Equity Income fund. Liquidity had fallen dramatically. A simple request to see the liquidity bucket analysis of the fund would have evidenced a serious rise in risk, while the sacking of unquoted stock valuation experts Duff & Phelps in 2018 would have set alarm bells ringing, had it been reported.

Woodford’s attempts to affect the valuation of unquoted stocks could now be deemed marking his own homework. Yet 25 major fund selectors and recommended lists continued to feature Woodford Equity Income as a go-to UK Equity fund. AJ Bell, BestInvest, Morningstar, RSMR and Square Mile, among others, still supported the fund, at least one researcher suggesting it was a good opportunity to top up holdings. Another exclaimed Woodford was “one to watch in 2018 – we continue to support him”, only to dump the fund a few weeks later.

One well-known fund management commentator called criticism of Woodford “investment trolling”. Even at the time of writing, another leading independent research business maintains the fund on its list but “under review”.

Treasury select committee chair Nicky Morgan has indicated she would support tighter regulation of so-called best buy lists. For ‘tighter’, read ‘any’. Other than a weak reference to impartiality and timely updates, the FCA has been conspicuous by its absence on the subject of regulating fund research.

As we prepare our Gatekeepers Report for 2019, we believe the fallout from the Woodford affair has served only to underline the need for an overhaul of fund research, and the production of buy lists.

Graham Bentley is managing director of gbi2

You can follow him on Twitter @GrahamBentley

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