Bad patch or just plain bad? Plenty of fund managers have underperformed soaraway stockmarkets in recent years – but that does not necessarily mean they should be sold. It may have been a unusually difficult time to determine whether an active strategy is performing well but, nevertheless, a number of rules still apply.
Broadly speaking, the market has not been kind to active managers over the last decade or so. Markets have been dominated by a handful of stocks – the technology giants in the US, TSMC in Asia, and Novo Nordisk and ASML in Europe. This has flattered the performance of both passive and quasi-passive funds, rewarding those managers who have stuck close to the index.
Active managers have also had to battle against a tide of outflows. According to the Investment Association’s report, Investment Management in the UK 2023/24, outflows from active funds were £31.8bn over 2023 while sales to index trackers were “far more resilient”, chalking up inflows of £13.8bn. This compares with £37.9bn flowing out of active and £11bn heading into index trackers in 2022.
“We are happy to back a manager through a tough period of time if we can understand why the performance has been poor.
Price discovery diminished
Such a preference for passive has been a phenomenon across the world meaning, among other things, that price discovery has diminished. This is particularly evident in certain markets – the UK, for example, has struggled under the weight of significant outflows.
The lack of participation at the small-cap end of the market has often left valuations out of step with fundamentals. Jack Barrat, manager on the Man GLG Undervalued Assets fund, points out price discovery has slowed – which can be a positive and a negative – and he goes on: “We can see the opportunities, but there is obvious concern over when those opportunities are going to be rewarded.”
Barrat says that companies buying back their shares and returning capital through dividends has helped, while rising merger and acquisition activity has also provided a boost. He believes, however, it would need a reversal in flows for the gap between valuations and fundamentals to close in full.
The UK is an extreme example, but a similar phenomenon has been seen in most markets, where flows into passive funds have supported the largest index stocks, leaving anomalies elsewhere. While active managers can make hay with the mispricing, the market has been slow to adjust.
Against this backdrop, it is tough to condemn a fund manager on performance versus an index alone. Peer group performance may be a stronger indicator but, here too, investors need to be careful about what they mean by ‘peer group’. It is a tricky moment to compare growth and value, for example.
“Performance is an obvious factor in our decision-making,” says James Burns, head of MPS at Evelyn. “We are happy to back a manager through a tough period of time if we can understand why the performance has been poor. As an example, their style might be out of favour and all their peers are also struggling – but, when a fund is an outlier and it boils down to purely poor decision-making then we will look to re-evaluate.”
Style drift
Burns also highlights the issue of process or style drift. This is a particular problem at the moment, when the dominance of the technology giants and other large-cap stocks has led some fund managers to edge away from their natural style in pursuit of easier returns.
“Sometimes the style we have invested in the manager for appears to have been left behind in an attempt to improve performance,” says Burns. “It is for this reason that it is always important to delve into the performance with the manager at regular update meetings to understand what they have been up to. Almost as bad as poor performance is great performance due to decisions being taken that are inconsistent with the philosophy and approach we have taken as reasons to invest in the first place.”
Darius McDermott, managing director at FundCalibre adds: “Fund managers deviating from their original mandate is a warning sign. If, for instance, you have invested in a value fund and notice mega-cap growth stocks creeping into its top holdings, that would definitely be a red flag. Generally, you are going to want a variety of styles in your portfolio at all times for diversification, even when some aren’t working.”
‘Too much money’
All fund selectors emphasise size as a key consideration. “With the great fund managers, quite often the thing that stops them being great is they end up running too much money,” says Simon Evan-Cook, manager of the VT Downing Fox Funds. “That even goes for Warren Buffet – when he was running smaller amounts of money, his returns were better than they have been over the last 10 or 20 years.
“In the UK, when a manager is running a fund of, say, £100m, that is ideally sized. It can go anywhere in UK equities – mid, small large cap. If they are running a gigantic fund, though, they can’t buy enough of that company to make a difference. If you’re running £20bn and you can only buy 30% maximum – and that can cause its own problems – it’s 0.1% of your fund. If it doubles, it’s 0.2%. Nobody is going to notice that. If it is a smaller fund and you put in 5% and it then doubles, you notice that. As a fund manager, you want the ability to put a proper weight into your best ideas.”
An obvious example of this was Neil Woodford’s short-lived operation Woodford Investment Management, where the significant inflows may have affected the style of management. Equally, if a large fund starts experiencing outflows, other investors may end up poring over the holdings, working out what the fund manager owns and driving down the price. Again, this was a problem for Woodford when his funds ran into difficulties.
Part of our analysts’ remit is to discover the current £100m fund that will become the next £1bn one so that we enjoy the benefits of early-mover advantage.”
“We are very happy to invest in smaller funds if we can see a runway to growth,” adds Evelyn’s Burns. “Part of our analysts’ remit is to discover the current £100m fund that will become the next £1bn one so that we enjoy the benefits of early-mover advantage.
“If this is happening in reverse, however, then we will be very wary as you do not want to be in a vehicle where all the biggest and most liquid names get sold first and you get stuck with the less desirable holdings.” As a result, Burns spends a lot of time looking at underlying liquidity of the funds he invests in as well as inflows and outflows.
Then, of course, investors need to take note of personnel and corporate changes. McDermott notes that, in the event of a fund house being taken over, investors will need to consider what is likely to happen to their portfolio and its manager. “Will the fund be merged with a similar portfolio from the other investment house?” he adds “Is the plan to trim down the number of products on offer? How about investment styles? If the fund is from a specialist, small boutique fund house, will it maintain its philosophy in the wake of being bought by a larger rival?”
For his part, Burns looks not just at a change in lead manager but also at any across the wider team. “Significant changes here would be a flag for us to investigate further,” he says. “The most obvious would be a raft of departures. It is also not uncommon for individual managers to leave firms to take on a new challenge elsewhere, which will often leave an unexpected void that is difficult for fund houses to plan for. If there is not sufficient back-up, this would normally be a catalyst for us to move on.”
It takes a confluence of circumstances – the right environment, the right level of assets, the right support – to allow fund managers to operate at their best. Should any of these factors wobble, it may be time to reappraise.
