Is picking funds an easy route to outperformance?
Kevfle recently posted an intriguing article called “Can we beat the professionals?’ In this he touched on some interesting questions around the investment industry, which provoked a flurry of responses from our fantastic community here at Stockopedia.
Kevfle seemed to have several questions on his mind, including:
Can we actually ever outperform the pros?
Am I wasting my time?
Is it easier to choose and evaluate a group of funds instead?
Can I achieve similar results leaving it to the pros?
In my previous article, I considered the first two questions regarding a more personalised investment approach. In the second of this two part series, I investigate the alternative option of buying funds and look at some of the difficulties that must be overcome.
Is it easier to choose and evaluate a group of funds?
Purchasing a group of funds (be they active or passive) has many advantages. Investing in a fund is an easy way to gain exposure to a certain market or asset class. They are efficient in gaining access to markets that are more difficult to trade in and and can provide the investor with a more diversified exposure for smaller investment sums.
Buying funds also requires very little time investment and you utilise the combined expertise of the talented members of the fund management team.
I will argue however that it is possibly more difficult to pick and evaluate ‘winners’ in this space.
The usual starting place for determining the level of skill of the fund manager is to look at how they have historically performed. Whilst we are all aware that we ‘cannot buy past performance’ it is still often used as a guide for how talented the fund manager is.
However due to the nature of luck involved in investment returns, past performance is a poor proxy for determining manager skill. Using returns data standalone, you would need a very long time series of return observations to have enough data to deduce a statistically significant outcome about a fund manager’s level of skill.
A popular way to filter the universe of funds is to use the Morningstar star ratings. These ratings are based on past performance and rate each fund between 1 and 5 stars, where 1 is the worst and 5 is the best. Seeing many stars on a fund factsheet may be visually appealing, however in line with above, a 5 star rating has been shown to be a poor indicator of future returns. It’s interesting to compare the three year performance of funds before and after they gain a 5 star rating:
We can see that the successful past performance leads to a higher rating, but the persistency of this performance is shown to trail off. The importance of this is noted by Morningstar themselves, who state:
“There are a couple of problems with using Morningstar's star rating for funds as an indicator of manager skill. For starters, though we've found that the star rating has some predictive abilities, all it really tells you is how well a fund has performed in the past, given the risks it has taken on. Just as past performance and alpha can't indicate future success, neither can star ratings.”
As the popular financial disclaimer notes ‘past performance is no indicator of future results’. When evaluating fund manager performance it is important to not just know how they performed, but also what they did to achieve that performance.
The importance of process
For those of you who have attended Poker nights, the concepts of process and luck can become very apparent. Looking down at your pocket pair of Aces, you are feeling very comfortable looking at a flop of J, 8, 5. After your raise and reraise, only ‘Crazy Eddie’ is left in the hand. The turn is a 2. Another raise from you and a call from Eddie. The final river card is a 7. In the showdown, Eddie shows a 7-2 to take the mountain of chips in the middle, whilst you bemoan to your colleagues about what just happened.
In a fair world, all good processes would be justified with good performance and all bad processes would be punished with poor outcomes. Unfortunately like other pursuits involving chance, investing outcomes are not so neatly distributed, with bad processes occasionally resulting in good outcomes in the short term. Similarly, the past performance of the fund is a poor signal for investment skill as from this alone we do not have any insight into the process used to achieve it.
Take the relative performance of one famous fund manager in the late 90s.
It would have been very difficult for an investor to stomach a c20% underperformance over these two years. Taken alone we may also conclude the fund manager had ‘lost their touch’. However it does not consider the style employed by the manager or the market context. The late 90s was a period dominated by a momentum fueled market with many investors who adopted a value style approach suffering. In the case above, Anthony Bolton’s fund (and other value managers) held a structural underweight to momentum stocks in this period, so when the market environment was against them, this led to significant relative underperformance. When the style in favour changes, this can have a large impact on the outcome of the fund - Anthony Bolton went on to outperform the index for 7 consecutive years.
The importance of process is understood within institutions. When an institutional investor is looking to invest in a fund, they will typically send a ‘Request for Proposal’ (RFP) document to the fund groups in question. These fund groups then proceed to fill out this document, answering queries which touch upon all areas of the business. This document will provide detailed insights into the investment process that the fund adopts, including the manager’s perceived edge, the selling strategy and what market conditions the fund will perform best in. The structure and stability of the business will be considered, including how staff are compensated and incentivised. It will provide details in the size and level of oversight from Operational and Investment Risk teams, software systems that are used and how trading is controlled. The due diligence may be reviewed from investment, risk and operational perspective to determine suitability.
From this document and meeting with the fund manager and risk teams, the institutional investor can develop their expectations for the fund and better understand the conditions when it it is likely to underperform.
Given the importance of process in determining the underlying skill of the fund, the retail investor is (unfortunately) unable to gain the same level of insight into the underlying process of the fund. Descriptions provided in factsheets and investment brochures are typically vague, focusing on the end goal without going into specifics of the process as to how this will be achieved. This lack of information can make it harder to decipher whether the manager performance has been due to style reasons, structural reasons or luck.
Going deeper - further process considerations
Knowing the investment process inside out is still not sufficient to fully understand the environments that the fund is likely to perform well in as there is another element to consider.
Suppose for a moment you invested in a rules based, quant fund prior to 2008. They had explained the years of research, hundreds of backtests and you had a full understanding of the process and how it will behave in different market environments. Then the financial crisis happened. Suddenly the fund has started taking positions that are very different to your expectations.
This is not a unique experience. In an article by Jim O’Shaughnessy, he noted that over 60% of quants overrode their models during the financial crisis. Years of research and development to distill a model, only to be thrown in the bin when put in a stressed environment.
“I know that as a systematic, rules-based quantitative investor, I can negate my entire track record by just once emotionally overriding my investment models, as many sadly did during the financial crisis.” - Jim O’Shaughnessy
Not only do you need to know the fund’s process, but also how the fund manager will behave in the periods when that process will inevitably underperform. Will the portfolio manager stick to their process given the career risk (that term again) or will they override their process to gain a relief from the pressure being applied to them? Choosing a fund is now not only a game of choosing a fund with a good process, but also choosing a manager who will be talented enough to know when to stick to the process (even under high pressure) and when to update the process to the constantly evolving marketplace. Had Anthony Bolton caved under pressure in 1999 to mirror the index, his subsequent performance would have been -5.9%, -13.3% and -22.7% from 2000-2003. His actual performance? +25.8%, +3.8% and -10.7%.
The next challenge
Suppose that you have overcome the previous challenges and have been able to identify a fund with a fantastic process and a manager that will consistently adopt this process. Subsequently the fund has had excellent performance. Financial press starts to celebrate the performance of the fund. The fund manager starts appearing on the covers of investment literature. Suddenly your hidden gem of a fund has become incredibly popular and the assets under management have ballooned from a couple million to billions. The fund now has a new challenge. Previously the manager had built a process around being able to dynamically enter and exit positions but this is now not possible due to the new liquidity challenges (as discussed in a previous article) from the increased fund size.
The negative impacts of increased fund size have been documented in investment literature, with some papers concluding that the larger fund size does result in relative underperformance due to the additional liquidity constraints reducing the size of the investment universe, resulting in diseconomies of scale.- The impact of this effect is likely to be related to the market cap of the stocks that the manager is targeting. A fund that invests in small caps is most likely to be affected by size constraints and as such may lose the nimbleness in their approach.
An insight into investor success
Perhaps one of the insights into how difficult it is to choose and hold funds is demonstrated through the returns that investors have received. One of the most successful funds in the 10 year period from July 1999 to July 2009 was the CGM Focus fund, which earned an annualised 17.8% total return, outperforming the S&P 500 by 640% over the period. The average annualised return of investors that bought this fund over this period? -16.8%.
Re-read that.
That’s right - the average investor who owned this fund actually lost money. Despite investing in a fund that was subsequently described as the ‘fund of the decade’ by the Wall Street Journal, the timing of investor flows meant that the money weighted return was negative.
Investors underperforming their underlying funds is unfortunately a recurring theme in the Dalbar’s Annual Quantitative Analysis of Investor Behavior and in investment literature, with Frieson finding “Investors in both actively managed funds and index funds exhibit poor investment timing”.
Note that this is not limited to retail investors. In the “The Selection and Termination of Investment Management Firms by Plan Sponsors”, Goyal and Wahal noted how on average funds that have been fired by institutions have subsequently gone on to outperform their hired counterparts.
We can understand some of the key elements at play here. Holding an underperforming fund can be hard, no matter whether related to style or luck. There is always a shiny new fund that is shooting the lights out and it is easy to justify the switch to the oversight committee (Yes, those who choose funds suffer career risk also).
As you can see there are several factors at play when choosing funds to invest. With thousands of available alternatives, buying a fund is very easy. Evaluating a fund on an ongoing basis however is considerably more difficult.
So reverting back to where we began. . .
Can I achieve similar results leaving it to the pros?
Without knowing an investors results (or desired results), it is of course impossible to say whether one could achieve similar results in a fund. For an investor performing in line with a passive fund after fees then the obvious answer is yes; if you are outperforming the index the answer is also yes - I just don’t know which fund will match your desired performance in advance.
Irrespective of the fund chosen, an investor should consider the impact of fees. When you invest in a fund, the fee applied is typically a variable fee (for example 1% on AUM). This means that as the size of your portfolio grows you pay more in absolute terms. If however you were to adopt a consistent trading approach of purchasing a fixed number of stocks at the start of the year, then no matter how the size of your portfolio grows, the commission fees are broadly fixed as they are based number of trades, not monetary amount (with exception to share levy of £1 for a £10,000 trade).
To provide a concrete example, assume that both you and the fund have consistent gross (pre-fee) return of 10%. For the fund, fees are based on start of the year value and charged at 1% AUM. For the investor, they have a generous fixed fee of equal to 1% of the starting value; as a result the charges after the first period are the same. (Note that in this simplified example I am ignoring Stamp Duty as it borne both by fund and investor).
From the chart we can see that we can build a larger portfolio value over time, without generating any additional return in comparison to our fund. This is because as our portfolio grows our relative costs decline, whereas our relative costs are constant for the fund. Cost savings compounding over time offer huge benefits. As John Bogle of Vanguard notes: “Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy.”
Conclusion
With thousands of funds to choose from and an asset management industry managing assets equivalent to 373% of UK’s GDP, investors are spoilt for choice when it comes to available options. The large number of alternatives have enabled investors to gain exposure to any niche they wish, however the sheer volume has possibly made it harder to identify and analyse funds.
Given the large sample there are likely to be winning funds that generate excess performance but we should not be deceived into believing that picking funds is an easy route. Similar to stock selection, capital allocation is a competitive business in itself, with trillions of pension assets seeking the best funds.
If one does choose to allocate investment capital to funds then we should ensure we know why we hold each fund and where it fits in our overall portfolio.
Photo by Raquel Martínez on Unsplash
About Oliver Cooper
I am a CFA charterholder and Head of Product here at Stockopedia. My job is to get the most out of our fundamental data by exploring new ways to present and interpret it.
My experience is predominantly based around Portfolio Construction & Risk; researching and implementing quantitative techniques to create better portfolios and make better decisions.
Disclaimer - This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
Hi herbie
That's the wrong way round.
Look at what they don't invest in, as opposed to what they do. None of those funds invests in commodities, many types of consumer cyclical, financials, telecoms, utilities and many types of technology company. We've had booms in IT, financials and oil stocks just this century - is it really believable that none of those things will ever have their day in the sun again?
Sure, wait until the bubbles subside and the quality will float back to the surface, but how many investors are willing to stand against the momentum these days?
timarr
"these funds are generally in different shares, Fundsmith more US large caps, Ashworth-Lord small/medium UK shares, Train larger UK shares."
That's true of Train's investment trusts and the Lindsell Train UK Equity Fund, but the Lindsell Train Global Equity Fund invests in international large caps including US ones.
Yes but commodities are unpredictable and may do badly in a recession. Actually Fundsmith does have quite a fair exposure to technology and IT, one reason why I think in a bear market it would not do so well. Fundsmith's 2nd and 3rd largest holdings are as IT companies, Amadeus IT and Microsoft, also it's largest holdings is PayPal which is financial. Train also has financials and IT in it's top 10. I don't know what their smaller holdings are. They will change their portfolios, one reason why I never bought Fundsmith is because a few years ago he had a high proportion of tobacco companies, this has now changed, note those companies have not done very well recently.
Fair point, I was only looking at the UK fund. I will have look.
The Train Global fund actually is similar to the UK one, the 2 largest holdings are the same as the UK fund. There are some Japanese companies. I see little overlap with Fundsmith, Train has more drinks, entertainment and consumer defensive companies, Fundsmith has more IT, pharmaceuticals/health and financials.
Rather than trying to pick individual funds, do people seek exposure to factors via ETFs?
e.g. https://www.ishares.com/uk/individual/en/products/270054/ishares-msci-world-quality-factor-ucits-etf
This to me would seem the easiest method of getting close to replicating stockrank factors.
I was at the office of a friend of mine (another fund manager) recently. A couple of things struck me:
1. A lot of 'fund of funds', 'family offices' and other institutional investors do due diligence on funds before they invest.
2. However based on my own experience (I manage a fund) and what I have observed I think a lot of people fail to ask the right questions or make the right observations.
3. I would humbly suggest the following key points:
A. Observe the fund manager at his desk. He is like a hamster stuck in a small box? Would you want to work in his environment?
B. What is the room density. My friend has an office with four desks regularly occupied (there are actually six desks). In approximately the same space in my office we have 12 - 15 occupied desks.
C. Can the hamster / fund manager influence his environment or is he limited in what he can do. (My friend has posters and fund items throughout the office. In my work environment our walls are bare).
D. How many layers of oversight? I know everyone wants to wrap the world up with oversight but frankly the character, personality and life experience of the fund manager is what you are investing in.
4. I once joined a very large fund management house where all the interviews were conducted in meeting rooms. It was only after I joined that I entered the 'trading floor'. My heart immediately sank. I think I could summarise the whole environment by describing the carpet - '1960s civil service, well worn and well stained'.
5. I appreciate the discussion was about how to select funds etc but let me suggest a hypothesis. Physical environments of where fund managers work change slowly. A good environment often ensures success. A change in performance is often associated with a change in environment.
Let me give an example of the above point. I once worked in a fund house where we were relatively successful. For various reasons we moved our office. Soon after one of the senior partners retired; followed by a couple of others. A new head of strategy was appointed. A number of new appointments were made in rapid succession. Within four years we went from the top of our game to a shadow of our former self.
6. I used to be dismissive of the term 'culture' - however the older I get the clearer it becomes to me that culture is hard to define but easy to ruin.
Here's an anecdotal example from John Authers at the FT:
https://www.ft.com/content/3c740106-c273-11e8-95b1-d36dfef1b89a
Unfortunately this is behind a pay wall, but in summary he bought the Capability UK Growth fund
from Capel-Cure Myers in 1992. It had one of the best 10 year records around, and he even had the chance to interview the fund manager. He invested £500, and after 26 years, this had grown in value to £3,160. If the £500 had tracked the performance of the FTSE All Share index it would have been worth £3,297. After tracker fees he thinks it would have been a little less than his fund, but as costs are more predictable than performance he recommends an index tracker.
Humour Me wrote:
"Rather than trying to pick individual funds, do people seek exposure to factors via ETFs?
e.g. https://www.ishares.com/uk/individual/en/products/270054/ishares-msci-world-quality-factor-ucits-etf
This to me would seem the easiest method of getting close to replicating stockrank factors."
Prompted by that post, I've looked at the performances of the various iShares Edge MSCI World Factor ETFs. The one that has performed the best over the past 3 years is the momentum one:
https://www.ishares.com/uk/individual/en/products/270051/ishares-msci-world-momentum-factor-ucits-etf#/
Buying that ETF seems a lot easier than buying portfolios of individual shares using Stockopedia's StockRanks and it has given comparable performance to a StockRanks or NAPS portfolio over the past 3 years, although of course the ETF is invested worldwide whereas the StockRank portfolios are likely to be solely UK based.
These factor ETFs have the advantage over active funds that one is not relying on a fund manager's stock-picking skills, which might not persist in the future.
What worries me about buying these ETFs is the fact that they use derivative products, so they have some counter-party risk. That has not been an issue in recent years, during a prolonged bull market, but if there is a major bear market I wonder whether their use of derivatives might cause them problems.
I don't know that fund and that seems a long time ago. Just been looking at some Vanguard trackers, the FTSE100 one is only up 1.77% over 5 years, that must exclude dividends. The FTSE250 has not been going 5 years but over 3 years it's up 9.7%. I will try to find some figures that inc. dividends and also for some of the better funds to compare.
Prompted by that post, I've looked at the performances of the various iShares Edge MSCI World Factor ETFs. The one that has performed the best over the past 3 years is the momentum one
Also prompted by that post :) I've been digging into ETFs as they seem an easy way of getting exposure. As part of this I came across this article which ranks exposure to different factors over time.
https://www.factorresearch.com...
There are several other interesting articles on that website.
ETFs do seem an interesting area to investigate and compare to a NAPS like approach. Good returns with lower volatility would be appealing.
Just touched the surface of this topic area though.
What worries me about buying these ETFs is the fact that they use derivative products, so they have some counter-party risk.
This is true for synthetic ETFs (initially popular in Europe) however there also exist physical ETFs which hold the underlying shares.
"ETFs do seem an interesting area to investigate and compare to a NAPS like approach. Good returns with lower volatility would be appealing."
Low volatility factor ETFs, such as the iShares Edge MSCI World Minimum Volatility UCITS ETF, seem to me to be good candidates for that:
https://www.ishares.com/uk/individual/en/products/251382/ishares-msci-world-minimum-volatility-ucits-etf
and also from the 10-year global performance record on the Factor Olympics website mentioned by HumourMe:
https://www.factorresearch.com/research-factor-olympics-q3-2018
However the iShares ETF uses derivatives, so it has some counter-party risk. Does anyone know of any low volatility factor ETFs that don't use derivatives?
What worries me about buying these ETFs is the fact that they use derivative products, so they have some counter-party risk. That has not been an issue in recent years, during a prolonged bull market, but if there is a major bear market I wonder whether their use of derivatives might cause them problems.
Lots of regulators have expressed concerns about synthetic ETFs - often the chains of counterparties are complex and as we saw in 2008 it only takes one link for that to fall apart. There are also concerns about whether the assets they hold are really correlated with the index they purport to follow.
The other problem with ETFs is the unwavering tendency of the fund management industry to leap on the next best thing and pervert it to death. One of the favourite tricks is to create synthetic indexes and then build ETFs to match.
Beyond that, however, there are concerns about the robustness of ETFs in a downturn. It looks like they played a major role in the flash crashes in 2010 and 2015. The SEC did a review into what happened and concluded that some of the pricing during the crashes was decidedly idiosyncratic - basically there's a suspicion that the market makers that are supposed to ensure that they don't trade outside a narrow range around the NAV simply withdrew liquidity.
And finally, of course, there's the hoary old chestnut that ETFs - particularly market cap weighted ones - drive more and more money into the big stocks leading to valuations that are out of synch with their underlying worth. If true that would likely unwind rapidly in a real crash where investors pulled their cash out of the ETFs causing the ETFs to sell the underlying overvalued equities.
Broadly - buy ETFs backed by physical assets and don't get too funky about the indexes they follow. And diversify.
timarr
However the iShares ETF uses derivatives, so it has some counter-party risk. Does anyone know of any low volatility factor ETFs that don't use derivatives?
The Vanguard offer implies direct investment.
https://www.etf.com/sections/f...
Personally though, I think a multi-factor approach should also reduce volatility as long as exposure to each factor is balanced. I can't make up my mind though about fund strategy .... whether it is better to select (in Stock terms):
- Equal weight exposure by V, Q, M factors
- Minimum V & Q & M fr selection (if >90 a very small universe, 0 in the UK so 90 = a bit too harsh, which implies a dilution of criteria that we know works individually)
- High stock rank (a composite of factor rankings)
Drivers of momentum are value (with improving fundamentals and/or forecasts) and/or quality (with improving fundamentals and/or forecasts). Momentum is an outcome of the other two, but operates slowly in individual shares due to under-reaction. Low volatility in individual shares is an outcome of 'agreement' = persistent high quality measures or lack of interest. Low volatility in factor based ETFs should be the result of some level of diversification, but too many holdings would to me suggest style drift. So composite or just momentum?
So in summary, at the moment I think I'll look for combinations of multi-factor or momentum, direct investment, regional (developed/ US/Europe), with limited diversification and a low expense ratio. Then wait for a good entry point if I'm satisfied. Or do a NAPS.
A good question, I read an article on Morningstar which said about 80% of ETFs in 2016 were physical, this had changed from 55% in 2011, so there has been a shift away from synthetic ones. Seems synthetics are mostly used for hard to access markets.
Has anyone got anymore up to date information?
I have been picking Investment Trusts based on long term manager performance before selection.
Require: Long term outperformance & same manager in charge.
After picking about 9 trusts, the average performance is several percent a year above benchmark etfs, measured from the date when I took the first position (mostly between 2007 & 2015). Prior to that, I didn't have any logical selection method.
One downside is since the manager has often been in place 10~15 years before I buy, they sometimes retire after I have only been holding a few years.
Beware, most of the studies saying you can't pick fund managers have 2 flaws:
1 They look at 3 year performance, or some other short term measure.
2 The studies are mostly based on the US market, which is known to be difficult to outperform.
The current portfolio is a mix of stocks, investment trusts and etfs. So far, my etfs are only for cases where there is no good Investment Trust option, such as buying gold, or investing in a single country like Poland.
I would want to see etfs tested over about 100 years before putting a high proportion of my portfolio into them.
Here's another article on whether funds show persistence of performance:
https://www.factorresearch.com/research-chasing-mutual-fund-performance
Hi jonesj, Thanks for your post, in which you wrote:
"I have been picking Investment Trusts based on long term manager performance before selection.
Require: Long term outperformance & same manager in charge.
After picking about 9 trusts, the average performance is several percent a year above benchmark etfs, measured from the date when I took the first position (mostly between 2007 & 2015)."
That's interesting. Would you mind telling us which Investment Trusts you have in your portfolio now?
Here is the list. The distribution is very uneven, with the largest position being over 5x the size of the smallest.
Some have been consistent stars. Others had a few very good years, followed by several poor years. Some have done nothing for years and have gone very well in the last 3 years. Plus the odd failure, like Black Rock Latin America.
Most of these have been long term holdings. The first 10 or would have been picked based on long term criteria.
Aberdeen Asian Smaller Companies
Aberdeen Asian Income Fund Ltd.
Jupiter European Opportunities Trust PLC
Templeton Emerging Markets Inv Trust plc
Scottish Oriental Smaller Co's Trust PLC
Fidelity China Special Situations PLC
Standard Life UK Small.Co's Tst Plc
Baillie Gifford Japan Trust PLC
JPMorgan European Smaller Cos Trust PLC
Baillie Gifford Shin Nippon PLC
JPMorgan Russian Securities Plc
BlackRock Latin American Inv Tst Plc
VinaCapital Vietnam Opportunity Fund Ltd
Fundsmith Emerging Equities Trust PLC
Schroder Oriental Income Fund Limited (new position, replacing some Scottish Oriental, as my very slow response to a mangement change at the latter)
The management also recently retired at Baillie Gifford Japan I believe.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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Just lost my long reply. Briefly I don't really agree, these funds are generally in different shares, Fundsmith more US large caps, Ashworth-Lord small/medium UK shares, Train larger UK shares. Fundsmith quite defensive, AL more adventurous growth companies, largest holdings are Games Workshop (LON:GAW), Craneware (LON:CRW) and Ab Dynamics (LON:ABDP). Train largest holdings Diageo (LON:DGE) and Unilever (LON:ULVR), so yes it seems Train is similar to Fundsmith but in different markets. You will probably have about 200 different companies. Fundsmith largest holdings are Paypal, Amadeus and Microsoft. All the same, I think they are all looking for quality but Al is a lot different from Train and Fundsmith's in my opinion. In a bear market I thing Train's will do the best and AL's the worst because he holds smaller growth companies. If the problem is just in the UK, ie Brexit then Fundsmith will do better. So I don't see these all performing equally. Worldwide recession then Train's should hold up and to a certain extent Fundsmith.