With all the articles in the press and business TV shows pushing the case for low-cost passive investing, we thought it was about time to bring some light to the other side of the story. That being those active managers who have outperformed, and how to find them.
The financial press would have you believe that no fund managers outperform the index, yet there are some prime examples of outperformance over the last 12 months:
- The Platinum International Brands Fund, which returned 24.92% for the last 12 months, more than double the index, which returned just 10.7%.
- The Antipodes Long Only Global Fund, which returned 17.44%, with the same benchmark.
There were many similar cases in Australia:
- The Macquarie High Conviction Fund returned 15.9% compared to the ASX 200 Index of 9.79%; and
- The contrarian, Dimensional Australian Value Trust added 17.95% compared to the same benchmark.
What we have found when it comes to the stories on passive investments, is that the analysis used is arbitrary and general gives no consideration to the style and investments that each fund is implementing. That is, there are a substantial amount of funds that simply replicate the index, but due to an arbitrary categorization, they are considered ‘active’ thereby bringing down the average. There are a long list of outperforming funds, both over the short and long-term, so in this short article we seek to provide 5 simple rules to assist readers in finding a good manager.
1. Find a manager that fits your purpose.
By this we mean that investors should not simply think about investing globally as just buying shares or any managed fund; that should consider the sectors, strategies or countries that they expect to perform well and invest accordingly. That is, if you believe Asia or Europe represents the best growth opportunity, then don’t buy a fund (like Magellan) that is more focused on US-based technology companies. If you believe that growth and technology companies have had their run and volatility may lie ahead, then seek a contrarian or value oriented manager. If you think dividends are undervalued, find one that focused on dividends and free cash flow.
2. Demand that management have ‘skin in the game’
As much as we hate this saying, more often than not it holds true. Would you prefer to invest into a fund managed by someone has their own capital invested alongside you and whose personal success and ability to pay their mortgage relies upon the performance of the fund? Or would you prefer to invest into a fund managed by a team of highly paid, salaried managers who are invested the capital of large institutions alongside your own? Our experience has shown that the best returns come in the early days after launching a fund, and you simply don’t get the same returns as AUM grows. There are of course some exceptions, however, in general we believe this holds true.
This is generally due to the fact that in a managers early days, they are striving for every dollar, working hard to maximise your returns. However, once super fund or institutional mandates come in (usually in the billions) these managers are now measured against their benchmarks and the alternatives on offer. If you consider an institution paying a management fee of just .20% of their $1.0bn in assets under management, that represents an income of $2.0m to the manager. It obviously becomes difficult sticking to one’s convictions when this sort of offer is available; hence the gravitation to index investing in order to minimise ‘underperformance risk’.
3. Minimise exposure to funds who have in excess of $2.0bn under management.
This relates closely to the previous point, in that investors should generally avoid individual funds that have in excess of say $1.0bn to $2.0bn under management. In our experience, this level of capital leads to increasing bureaucracy, longer decision-making processes and generally worse results for investors. More assets under management generally means a manager has several institutional mandates and is now being covered by ‘investment consultants’ who focus solely on their performance against benchmarks. There are generally more meetings, more travel and less time dedicated to digging deeper into investment opportunities. In addition, funds of this size can also find it difficult to identify attractive opportunities particularly where they invest in smaller, less liquid markets.
4. Look for a team, rather than individual based portfolio management process.
By this we mean that investors should be seeking managers who have a process that can be easily replicated and have a succession plan in place. Investing in fund that relies solely on the ideas, analysis and nous of a single portfolio manager puts you at risk of underperformance should that person decide to retire. We recommend investors look to funds that have co-portfolio managers, who make investment decisions as a committee and value the input of every member of their team. Focus on those managers who consider the ideas of every team member and place more value on idea generation than on short-term performance.
5. Understand the risk management process of each manager.
Risk management processes relate to what each manager will or won’t do when things go wrong. If you are worried about protecting your capital make sure you have a manager that implements strict stop losses on positions that go against them. Ensure you have an understanding of how they determine weightings for each investment in the portfolio, the minimum and maximum number of and allocation to each investment and the amount of time they will give to an investment that goes wrong. In this point, you should be looking for managers with expressly stated and implementable capital protection strategies who have the wherewithal to implement them when times get tough. Take for instance, Nick Griffin, of Munro Partners, who was published in the Financial Review this week for indicating that on the first sign of difficultly, he sold out of a major holding to protect investors capital.
It goes without saying that there will always be exceptions to these rules, however, we believe they are a great starting point for investors seeking better returns.