Has Neil Woodford lost his magic touch?

Fund manager Neil Woodford has a phenomenal long-term record of generating wealth for his investors. Indeed, £10,000 invested in Woodford's fund when he started at Invesco Perpetual in the late 1980s would now be worth over £300,000 -- that's more than twice the amount you'd have got if the money had been invested in the FTSE All-Share index.

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However, 2016 was a disappointing year for Woodford, with his Equity Income Fund returning an underwhelming 3.19%, which is significantly below the FTSE All-Share index's return of 16.75%. Should Woodford investors be worried? Has the fund manager lost his magic touch?

Active management

Before we drill down into Woodford's 2016 performance, it's important to examine the legendary fund manager's investment philosophy and think about what he's trying to achieve.

The first thing to understand is that he's a long term investor, focused on fundamentals and valuations. He believes that by focusing on valuations and identifying companies that can deliver sustainable growth, he can generate excellent long-term returns for his investors. Woodford acknowledges that equity markets can be driven by sentiment in the short term, but stresses that it's the long-term performance that counts.

Investors should also be aware that Woodford's fund is very much "actively managed". This means that Woodford isn't simply trying to replicate the returns of the market, but instead attempting to add value through the investment process. Whereas many fund managers prefer to 'hug' an index, staying with the herd, Woodford isn't afraid to make bold decisions and stick with them. The result is that at times, as Woodford explains, his fund "will not look or behave like the broader UK stock market".

2016 underperformance

With that in mind, we can get a better understanding of why he underperformed in 2016, and the fund manager explains that "much of what we saw in 2016 does not appear to be grounded in fundamentals."

Indeed, Woodford offers Royal Dutch Shell as an example of a company that enjoyed strong share price momentum in 2016, rising over 50%, when the fundamentals of both the company and the sector still look shaky. Woodford continues to avoid the oil sector on the grounds that the fundamental backdrop for oil prices remain weak, and that dividends in the sector are still vulnerable.

Also contributing to the underperformance of the fund was a large weighting towards healthcare. Woodford believes this area offers investors an "exceptional opportunity" and states that he sees "a lot of value being stored up in the sector", with promising drugs coming through the pipelines of both small and large companies. He explains that the market has failed to acknowledge this value in the last 18 months but insists there's considerable long-term value in the sector.

Where to now?

Despite Woodford's below-par performance in 2016, investors should realise that investing is a long-term process and that even the best fund managers may underperform in the short term.

It's important to remember that Woodford is investing with a multi-year investment strategy and that one below-average year should be put in context of a phenomenal long-term track record.

Woodford insists he enters 2017 in a "confident and optimistic mood" and that despite challenging market conditions, he sees no reason to position his portfolio differently. For this reason, I'll be sticking with the fund manager for now and backing him to succeed in the future.

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Edward Sheldon owns shares in Royal Dutch Shell. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.