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John Chatfeild-Roberts shares his approach to active asset management and why he thinks it is a better option than passivity.
“Life has no rehearsals, only performances.” Anon
When it comes to fund investing, getting it right is never easy. So it is understandable that some investors believe they might as well buy ‘passive’ funds or index trackers rather than concern themselves with individual fund performance or pay more for an actively managed product.1
Unfortunately, following the herd only ensures good performance while the market is going up – in a straight line and with little volatility. In recent years, the opposite has often been the case. As a result, investors have had to absorb a frightening amount of volatility and, over the last decade, watch the value of tracker portfolios go nowhere.
By contrast, many of those that invested with the top performing active fund managers have seen their losses to capital mitigated in tough times, locking in much of the value obtained when markets were buoyant. On the other hand, investors in actively managed funds that performed badly over that period will have a different story to tell.
The case for active management
Nonetheless, active management both on the part of the fund manager and their client has certain irreducible benefits, the most significant being flexibility. Flexibility allows active managers to pick stocks they believe will outperform the index and move rapidly to aim to protect investor capital before crises hit. If they make a mistake, they can also act quickly to correct it. Conversely, passive funds remain solely at the mercy of market sentiment. In recent years, this has come to be dominated by the short-term trading of hedge funds.
Take the past five years of rapidly changing markets as an example. If you had put money into any one of the top ten actively managed UK equity funds over that time frame, your money would have grown by more than 51.7 per cent by 31 July 2010. On the other hand, an investment into the top-performing passive fund over the same period would have gained you less than half that – only 24.8 per cent.2 But note that past performance is not a guide to the future, and the above trend may not continue.
Cost and performance
Passive funds are usually offered at a lower price than active ones. But cheaper does not always mean good value. Most passive funds will inherently underperform whatever index they are attempting to mirror because the cost of buying into the vehicle is subtracted from the performance.
And this can happen even when the market is going up. For example, during the frenetic years of the dotcom boom, tech stocks went through the roof. These companies’ growing weightings in UK indices forced many tracker funds to scramble to buy tech shares at any price, thereby incurring a significant opportunity cost.
More recently, tracker funds following the FTSE 100 index, of which until recently BP made up a massive proportion, could only sell the oil giant’s stock once the Gulf of Mexico crisis had hit the share price and its weighting had slumped. Whenever you have investors who cannot make investment calls based on company fundamentals, anomalies are bound to occur.
On the other hand, a good actively-managed fund offers the opportunity to outperform an index, even after its higher charges are deducted. This may be difficult to find as not every fund manager out there will succeed, and even successful managers can underperform in certain markets, but it is not impossible. Out of the 4,000 possible funds available in the UK, you only need find 10 to15 good ones to have a powerful portfolio that can deliver robust long term returns.
Consistency
Commentators may argue that it is difficult for fund managers to perform well on a consistent basis year after year. While that may be true of some, investors who select the right managers may find it is not always the case. My own research, published in my book Fundology,3 into the performance of 100 UK equity funds in the 20 years since 31 December 1985 showed that 39 per cent of them beat the index during that time.
Of those who beat the index over the first 10 years, 72 per cent repeated the feat over the subsequent 10 years. So managers who can outperform on a consistent basis do exist; and depending on their talent for spotting opportunity and making the right decisions can continue to produce strong returns for investors over a multi-year period.
Identifying outperformance characteristics
As there can be no guarantee that even a strong track record will continue, good asset management firms take great pains to identify those characteristics it believes are most likely to lead to outperformance. There are many technical ways to identify manager ability: past performance, Sortino ratios and standard deviation to name a few. But such analysis is only a part of the process as I believe managing funds of funds is first and foremost a people business.
This means continually meet and review the fund managers selected, noting both their performance and subtler details such as how they view their job and life in general, the kind of backup they have and the company they work for. It is also important to consider the market conditions they prefer. Even fund managers who are currently out of favour may be top performers under different circumstances.
Asset allocation
However, just picking a good manager is not enough to produce good performance. Holding the top performing fund in a sector is all very well, but if the sector is underperforming significantly, that is of little use to investors. So I am a strong advocate of asset allocation and we spend a lot of time researching and analysing markets and sectors. Then we take a view on which are likely to perform best and buy the right funds to do the job. This may occasionally include passive vehicles such as an exchange traded fund,4 but this is only when we require exposure to a specific asset class for a specific time period.
One recent asset allocation decision was being underweight in the euro. This helped shield investors from the fallout of the debt crisis in southern Europe in the second quarter. Holding little sterling also proved beneficial. The inverse of this allocation decision was being overweight in US dollar, which profited from its reserve currency status despite concerns about the US economy. However, this position was also a function of our fund selection. Holding Findlay Park’s American Smaller Companies Fund (see figure 1) gave us exposure to our preferred asset class and our preferred manager.
Remaining defensive throughout the crisis has proved useful, though it occasionally cost us short-term performance as oversold, indebted stocks experienced sharp rebounds. Nonetheless, we continue to favour quality large caps with strong balance sheets which are able to grow their dividends despite the weak backdrop, and take market share.
We have never favoured hugging the index and, in the case of BP, were underweight when disaster struck in the Gulf of Mexico. Not holding miners proved positive in early summer, while allowing cash to build up and holding gold helped protect investor capital as major equity markets retreated in the second quarter.
Other areas we took greater exposure to in the last 12 months were technology and selective countries in Latin America, specifically Brazil, Mexico and Colombia. While investors continue to be wary of tech stocks a decade after the dotcom crash, some companies have used strong product pipelines and relatively strong balance sheets to maintain growth in a difficult environment. Certain Latin American countries have a domestic growth story that persists despite the global climate. House builders for example have been doing roaring trade in Brazil while being on their knees in the US. So there are areas of potential growth in the world but it is not always a straight line to riches.
Summary of key points:
- Following the herd only works when markets are rising.
- Flexibility is a key benefit of active management.
- Choosing the right person to manage your fund is essential.
- Asset allocation is a moral obligation.
- Uncertainty brings opportunity.
1. See also ‘Implementing your investment policy’ in Caritas, Guide to Finance, June 2009, page18. www.charitiesdirect.com/ caritas-magazine/implementing-your- investment-policy-454.html
2. Financial Express. Figures calculated: bid to bid net income reinvested. Number ten of the top ten active funds was Standard Life UK Equity High Alpha Fund which returned 51.68 per cent over the period. Top performing passive fund was the Halifax UK FTSE All Share index tracker
3. Published by Harriman House Ltd 2006
4. See ‘Asset flexibility’ by John Redwood in Caritas, issue 11, October 2008
Author: John Chatfield-Roberts
John Chatfeild- Roberts is chief investment officer of Jupiter Asset Management.
After his degree in economics and a short service commission in the Army, John started his fund management career at Henderson's (1990 -1995), followed by a move to Lazard Asset Management, where he set up a successful multi-manager team from scratch.
He joined Jupiter in 2001.
John is a fellow of the Securities Institute.
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