The events surrounding the closure of the Woodford fund – detailed in the recent Financial Conduct Authority's final notice to the fund’s authorised corporate director (ACD) Link Fund Solutions – has left many in the industry wondering how things went so wrong.
The whole saga has also once again shone a light on an often overlooked but critical function in fund management.
For anyone who was able to find several hours in their day to look through the final notice, the regulator left more than enough clues about what led to the fund’s failure.
One of the central issues raised by the FCA was the participation rate Link used in the way it monitored the liquidity of the fund.
Link had assumed a participation rate of 100 per cent when applying certain of its liquidity metrics.
A 100 per cent participation rate assumes that the entire volume of a security that was traded on a given day could be sold without affecting the price of that security.
Link asserted that this optimistic assumption was offset by the requirement for all of the holding in that security to be sold before it could be included in the relevant liquidity time period.
However, this was not the case in practice, the FCA concluded. The use of a 100 per cent participation rate was unrealistically optimistic and led to an unjustifiably positive assessment of the fund's liquidity.
Had a more reasonable and appropriate participation rate been adopted, actions would have been triggered under Link’s own liquidity thresholds.
The issue of the 100 per cent participation rate formed the subject of a comment in a s166 report issued to Link by a skilled person on October 19 2018.
The report made a note of the 100 per cent market participation rate being an optimistic assumption in the context of a sell off.
It also noted that the participation rate was outside normal market practice, where a 20-30 per cent participation is typically assumed in good market conditions or 10 per cent in a stressed scenario.
The skilled person recommended in the report that Link revisit the market participation rate of 100 per cent, but no changes were made to the rate used.
Speaking to a number of people in the industry with experience and understanding of participation rates, a combination of surprise and shock was expressed that a participation rate of 100 per cent was applied to the stocks in the Woodford fund.
This is because, broadly speaking, 100 per cent would typically only be applied to a highly liquid stock or a stock that is traded a lot.
So for example, if you had a large-cap global equities fund with £100mn invested in it, you could easily sell all of the £100mn in one day.
If all the clients want their money back the stocks could be sold immediately.
But if the £100mn was invested in a micro-cap company, the chances are it would not be possible to exit all £100mn in a single day.
