Low investment returns pose significant risks for investors, and their advisors. Their returns may not be sufficient to achieve their financial goals. But if they then go ‘chasing yield’ they can fall down the mineshaft of illiquid assets and become trapped.
Hundreds of thousands of investors in the United Kingdom are living that pain right now. Since June 2019 almost three billion pounds (US$5 billion) of their savings has been frozen in a fund that portrayed itself as a ‘safe’ investment. In December it was announced that the fund would be wound-up, and all investors will incur the heavy losses.
The sad story of Woodford
Neil Woodford was a celebrity fund manager in the UK and his ‘Woodford Equity Income’ fund attracted a lot of money with its promise of above-par returns and regular distributions.
But it was a house of cards. The fund was filled with illiquid assets that could not be easily sold if a rush of redemptions came — which is what happened in the middle of 2019. Once the fund was frozen the sad truth came out, that much of the money was tied up in assets that simply could not be sold.
This meant that the liquid, ‘good’, investments were sold off first — leaving the fund with nothing but the illiquid junk. No-one knows yet just how much the investors will lose, but some estimates put losses at 30%-60%.
This all came as a total shock to investors and advisors, who believed they were invested in a relatively safe income play. Since the Woodford freeze other UK funds invested in illiquid assets such as commercial property has suspended redemptions.
There’s no free lunch
Safe investments and above-market returns are at different ends of the risk spectrum. Leaning toward one inevitably means leaning away from the other. A big part of financial planning is to work out what direction and angle of lean is right for each client.
But in an era of low yields that calculation becomes tough. It’s become harder to make people’s financial plans work out, because their money is not growing as they had hoped.
The temptation to ‘chase yield’ has never been higher. But the risks of doing so are often poorly understood. A freeze on funds or a loss of capital can be catastrophic for a person’s financial plans and future.
Where’s my money?
The Woodford investors are a good example of how things can go wrong.
First, their investment was frozen. If it were temporary that might not be problem for some, provided their income payments continued. But the income stopped, so they had to reduce their expenses or sell ‘good’ assets to survive.
Meanwhile, desperate to raise cash the fund sold what could be sold, leaving a rump of illiquid assets behind. Investors can only hope to receive back a small portion of the money they put in when everything is eventually liquidated.
Individual investors face a similar path when things go wrong.
If income stops, they might need to sell down assets to meet living costs. If large blocks of capital are lost their savings will be depleted far earlier than expected.
It can become like a snowball rolling down a hill, growing in speed and size as it rolls on. Surprisingly quickly, financial plans can be decimated.
Is it a suitable investment?
The tests of suitability are very important when considering investments that offer above-market returns.
First, it must accord with the investor’s risk tolerance and risk profile. To truly test this, you must consider the impacts on goals should the funds be frozen or lost.
Second, you must know the product so the client can know what they are signing-on for. This can be harder than it first looks. UK investors thought that the Woodford income fund was ‘safe’ — the exact opposite of what they were invested in.
Third, you must have good reasons why this client and this investment belong together. Maybe they do need to chase that yield, but maybe they could achieve their goals a different way — perhaps by delaying retirement by a year and earning extra salary.
Fourth, you must explain to the client the best-and-worst case scenarios so that they can make an informed decision to proceed. Again, this can be harder than it sounds because different clients will have different levels of knowledge and understanding.
Finally, you have maintained an eagle-eye watch for any changes in the client’s situation or the nature of the investment. The Woodford fund became more illiquid and riskier as time went on, but some people recognized this early and were able to get out before it all went so badly wrong.