Neil Woodford’s Basic Economic Problem – He’s Got A Liquidity Mismatch

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We’ve all seen that wondrous suspension of redemptions in Neil Woodford’s Equity Income Fund. The interesting question obviously being well, what in buggery happened? The answer being something that’s not unusual in the slightest. There’s a liquidity mismatch in the basic set up.

This is usually most evident in banking. The banks takes in our deposits as short term loans from us to them. We can go ask for them back any time. The bank then lends them out longer term, for months or years. So, if we do all ask for them back at the same time we get this:

The answer is the central bank steps in and provides the liquidity to the bank. Only to those solvent but illiquid of course but that’s the solution. For there to be a liquidity provider.

What’s happened to Woodford? He takes significant positions in often second rank stocks. It’s trivial to buy or sell a few hundred shares in these things. But you can’t move in or out of them in 10 or 20% of the equity in issuance, not easily. Not quickly, or if quickly not at anything like market price for more modest stakes.

Woodford has been promising total liquidity to investors. He’s got a liquidity mismatch – investors can have their money back faster than he can move in the underlying investments. It’s a basic problem:

Essentially, be aware of this problem. Sure, most open ended funds, invested in whatever and however illiquid, won’t come up against this problem. But any that do will have only one of those two choices. Dump positions to fund redemptions, in which case we lose part of our investment. Or suspend redemptions in which case we’re losing the very thing we went into such a fund for, liquidity. An open ended VC in early stage companies fund would be ludicrous – which is why they’re all close ended and insist on 5 year redemption periods. An open ended Treasuries fund is just fine – we’ve all got larger problems if those markets freeze over. Somewhere in between is the line and strategic positions in second line equities seems to be the wrong side of it as might be corporate bonds and commercial real estate.

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