Why doesn’t Woodford Equity Income have a top Morningstar rating?

Neil Woodford

Morningstar has upgraded the Woodford Equity Income fund from a bronze to a silver rating this week, but the ratings agency says star fund manager Neil Woodford will have to establish more track record delivering on his small-cap and unquoted positions to get the top rating.

The rating upgrade followed a stabilisation in staff turnover and the firm’s recent move to improve transparency in the fund’s fee structure.

Since its launch in June 2014, the fund has returned 26.8 per cent compared to the FTSE All Share index, which has returned 8.3 per cent.

Less than six months after the fund’s launch, chief operating officer Nick Hamilton and chief legal and compliance officer Gray Smith left in a shock double departure.

Senior manager research analyst Brunt says high staff turnover can be expected in a start-up business, but that Morningstar feels reassured this has since stabilised at the firm.

In April, Woodford Investment Management said it would foot the bill for research costs rather than investors. In 2015 the total cost of investing in the Woodford Equity Income fund was 0.84 per cent, of which 0.02 went on research.

Brunt says while Neil Woodford’s track record at Invesco Perpetual informs the fund’s rating, his portfolio is now more reliant on small and unquoted companies to drive alpha.

“He’s now investing a lot more further down the cap scale and he’s also investing more in unquoted companies. He did hold unquoted companies at Invesco Perpetual, but to a lesser degree,” he says.

Furthermore, around 70 per cent of the fund was invested in large cap companies, Brunt says.

“When he was at Invesco Perpetual the big alpha drivers were from him taking very strong macro calls,” Brunt says. “That was nicely identified in the lead up to the financial crisis. He didn’t hold any materials, which were very high yielding at the time, he didn’t hold any banks, he had a negative view of the economy.

“Many of his funds didn’t perform well in the lead up to 2007 and 2008, but when the financial disaster came into effect his fund was a lot more resilient.”

In May, Woodford admitted the Equity Income fund had underperformed the benchmark due to avoiding commodities, which it believed were rallying due to speculative behaviour, particularly in China.

Brunt adds that the research house will keep an eye on whether an increase in assets under management would impact Woodford’s ability to be able to invest in smaller companies.

“As assets start to grow he may not be able to be so nimble in all these companies. Inherently they are an illiquid asset class and he might not be able to take the stakes he wants to in these companies,” he says.

“That would mean that he would either have to not invest as heavily in unquoted companies or he would have to invest in more unquoted companies and thereby you would think they wouldn’t be his best ideas.”

Brunt says there is no example of a fund manager in the UK equity income space establishing a gold rating within three years of going out on their own. He adds that Woodford is among the best fund managers in the UK and possibly globally too.