Is picking funds an easy route to outperformance?

Monday, Oct 15 2018 by
35
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…

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Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. The author may own shares in any companies discussed, all opinions are his/her own & are general/impersonal. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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43 Comments on this Article show/hide all

herbie47 17th Oct 24 of 43

In reply to post #409734

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. 

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timarr 17th Oct 25 of 43

In reply to post #409784

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

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pka 17th Oct 26 of 43

In reply to post #409784

"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.



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herbie47 17th Oct 27 of 43

In reply to post #409794

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.

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herbie47 17th Oct 28 of 43

In reply to post #409799

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.

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HumourMe 18th Oct 29 of 43
1

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.

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roddy10 19th Oct 30 of 43
2

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.

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dodge1664 19th Oct 31 of 43

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.

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pka 19th Oct 32 of 43
2

In reply to post #410084

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.

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herbie47 19th Oct 33 of 43

In reply to post #410249

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.

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HumourMe 19th Oct 34 of 43
1

In reply to post #410279

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.

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pka 19th Oct 35 of 43

In reply to post #410334

"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?

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timarr 19th Oct 36 of 43
1

In reply to post #410279

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

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HumourMe 19th Oct 37 of 43

In reply to post #410364

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. 

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herbie47 19th Oct 38 of 43

In reply to post #410364

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?

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jonesj 19th Oct 39 of 43
1

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. 

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pka 20th Oct 40 of 43

Here's another article on whether funds show persistence of performance:

https://www.factorresearch.com/research-chasing-mutual-fund-performance

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pka 20th Oct 41 of 43

In reply to post #410429

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?

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jonesj 20th Oct 42 of 43
1

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.





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pka 22nd Oct 43 of 43

In reply to post #410484

Hi jonesj, thanks for sharing your investment trust portfolio with us.

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