Fund Management: The Facts They Don’t Want You To Know

5th Dec '11 by Niels Jensen

9 comments 23683 reads

What have Bill Gross, John Paulson, Anthony Bolton and Bill Miller all got in common? They are all ‘rock star’ fund managers who have fallen on hard times more recently. Life in the fund management industry is not what it used to be like. Life is tough even for the supremely skilled. Markets are changing, fund managers are struggling to adapt and clients are growing restless as a result.

If I told you that the composition of an average UK equity fund changes by 90% a year, would that startle you? How would you feel if I added that the 20 funds with the highest turnover returned just 4.7% to investors in the 3 years to the end of March 2011 whereas the 20 funds with the lowest turnover returned 16.8% over the same period?[1]

From the same source: Out of 1,230 funds across 12 different strategies, only 35 fund managers produced a performance consistent enough to earn their fund a place in the top quartile in each of the last three years. In a universe of 1,230 funds, over a three year period and completely disregarding skill, the expected number of funds consistently ranked in the top quartile is 1,230*0.25³=19.22.

In other words, more than half the 35 managers were there not because of skill but because, statistically, someone was always likely to ‘over-achieve’. This leaves about 15 fund managers out of a universe of 1,230 – ca. 1% - who could with some right claim that they have consistently been in the top quartile.

The problem is we don’t know who they are. All we know is that none of them are managing Asian equities, North American equities or Global fixed income funds as those three strategies didn’t produce a single top quartile performer between them. And when you look at the second, and slightly less demanding, part of the study – those who have been in the top half in each of the past 3 years – the picture is broadly the same (lower half of chart 1). 177 fund managers achieved the required consistency but 154 of the 177 are likely to have done so because of luck, not skill.

I have never come across a fund manager who openly admits that his (or her) outperformance is down to luck. On the other hand, I often come across fund managers who suggest their underperformance is down…

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Rob Davies

5th Dec '11

What a bizarre article. It says active management doesn't work and then goes on to say you should Identify and then stick with "good" fund managers.

narp

11th Dec '11

I have an index tracker fund in my pension scheme. I think it's one of the best one in the current circumstances as I contribute monthly, so I get more units for every pound as the index goes lower and only have to worry where the index is when I come to retire.

Buildalot2013

3rd Aug '13

The article started well but then the logic (and contradiction )simply causes the arguments to collapse. Agree entirely with above McEssex's comments

speedie2

17th Oct '15

an interesting article on a complex subject. Further debte on various points would be useful.

VegPatch

19th Oct '15

Interesting debate, and one I am live to every day as I work in the industry.
I do see one HUGE contradiction though. The author talks about only a handful of fundmanagers having the consistency to be top quartile every quarter, but in almost the same breath decries portfolio turnover. If you are going to be long term and invest with say a 3-5 year horizon then there will be times when your portfolio does underperform. This, in my mind, is a certainty. You can't have it both ways. Just look a Neil Woodford, he tends to underperform a rising market but does well in bear markets, such that over the LONGER term his funds have outperformed strongly. His last investment letter stated that his portfolio churn over the last 12 months implied a 6 year holding period ie c17% pa. Personally I think that qualifies as long term. One point I do agree with is that 90% turnover is simply too high as it incurs costs like bid / offer spreads and stamp duty. You will find it hard to outperform if you continue to incur those costs on an annual basis.

Maybe you should judge your fundmanager not over a quarter or 6 monthly period but over the longer term? Most clients are fantastic, but I do see a few clients who tell me they are v long term orientated, but want to know why the last month has seen the fund lag the index. Fair enough as it's their money, but I really don't try to think short term as you start to double guess yourself and lose sight of the fundamentals. I never use the word luck in either good or bad sense over the short run, but I do try and explain that in the short run the market is a voting machine and the long run its a weighing machine (one of Ben Graham's famous allegories). The key is to explain your process clearly, stick to it, and make sure clients understand it an are happy with it.

Also to beat the pack, you also have to go where others don't. If you just replicate what other fund managers do in composition if holdings you will have results that essentially mimic theirs. So again this is likely to necessitate periods of underperformance. Consistency of outperformance over quarters is hugely desirable (I would love it!) but really not likely.

The key is to construct a portfolio to try and mitigate underperformance due to individual shares performing (eg if a 10 share portfolio was evenly balanced with 10% in each one, if one has a profit warning and falls 30% but the others rise 5%, the portfolio still rises 1.5%. Not the end of the world. But consider if the portfolio has the same 10 shares but distributed 40% in one (where the PM is supremely confident...) and 60% in the other 9 holdings. If the largest holding has the -30% profit warning and the rest do 5% growth, the portfolio falls 9% despite the portfolio owning identical companies to the first example. This shows the importance of good portfolio construction. Limiting the fund's drawdown in the bad times is just as important as performing well in the good times if you want to outperform over the longer term.

I hope this adds to the debate

VegPatch

vicA

17th May '17

My belief is that human error is what makes a business fail till I read this blog. There are a lot of human factors why a business fail, when I'm down to my luck, I wasn't able to pull my business back together, up until now I am still trying to correct those mistakes. Lucky for some, who were able to climb back through right away. As per procustomwriting, I write for now with their help as part of my regime on my way back to the stream.

shipoffrogs

Isn't 90% annual turnover just someone persistently correcting their errors? And failing.

jonesj

I DON'T require the kind of consistent short term performance demanded in the main article.
To require someone to be in the top quartile in each of 3 consecutive years is way too short term. This tends to be the kind of argument used by supporters of indexing, when they want data to support the pro indexing stance they already have.

All I look for is significantly out performing the benchmark index over 2 consecutive 5 year periods. If they underperform in individual years, who cares?

Graham Codd

16th Aug '17

The main problem with smaller companies is that to acquire a decent spread is very expensive for someone prepared to invest only £10,000 in them. 20 holdings of £500 with costs of £14 each, costs £280 to buy, £230 to sell, plus monthly platform fees. It does not take many to go pear shaped before the investor is out of pocket. I invested in Fidelity Special Situations Fund which I believe Anthony Bolton was managing and various smaller companies unit trusts. Most of these delivered returns of over 35% annually Obviously I would have made more if I had chosen the correct shares, but at least I spread my risk. Woodford has never performed as well for me and with experience I find a mixed portfolio works better with dividends reinvested in an Isa.

Fund Management: The Facts They Don’t Want You to Know

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Niels Jensen

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