Navigating the Investment Maze: When to Stick with Your Fund Manager and When to Cut Ties
Investment fund managers are often lauded for their supposed expertise, commanding substantial salaries and bonuses. Investors, in turn, foot the bill through various fees, with the implicit understanding that these professionals will consistently outperform the broader market. However, a closer look at the performance data reveals a surprising truth: a significant number of these highly paid experts struggle to consistently deliver returns that outshine the much cheaper alternative of passive index tracker funds.
The reality for many investors is that active funds, which rely on a manager’s stock-picking prowess, frequently fall short. Over the last decade, analysis by the investment platform AJ Bell indicates that a mere 16 per cent of global equity funds managed to outperform the MSCI World index trackers. Similarly, data from Bestinvest shows that only 6 per cent of US-focused funds available to UK investors have managed to beat the S&P 500 index over the same ten-year period. This starkly suggests that a substantial portion of investors would have been better off opting for a low-cost index tracker, a passive fund that simply mirrors the performance of an entire market. The premium paid for active management, typically around 0.8 per cent for a global active fund compared to 0.1 per cent for a global index tracker, often fails to justify the performance gap.
While there are indeed exceptional active funds that do achieve market-beating returns, the exceptional performance of passive options like Fidelity Index World, which returned a remarkable 76.2 per cent over the past five years, makes it increasingly difficult to justify the higher fees associated with human fund management. This raises crucial questions: are there specific markets where active stock picking consistently proves its worth, and more importantly, how does an investor discern when it’s time to move on from an underperforming fund manager?
Identifying the Right Moment to Sell
It’s natural to feel the urge to divest from an investment that has experienced a downturn. However, before parting ways with your fund manager, a crucial first step involves dissecting the reasons behind your active investment’s underperformance.
Understanding the Performance Gap
- Market vs. Fund Performance: The initial investigation should focus on whether the entire market or sector has faced headwinds, or if your specific fund is the sole underperformer. A useful tool for this is the fund’s benchmark. By comparing your fund’s performance against its designated benchmark and the average manager within its peer group, you can gain valuable insights. This information is typically readily available on the fund’s monthly fact sheet, which offers a comprehensive overview of its performance, holdings, risk profile, and investment strategy.
Patience and Investment Styles
Dan Coatsworth from AJ Bell advises a degree of patience. “No fund manager can be expected to do well every single year,” he notes. “You need to have more patience than you might think. Sometimes their style of investing will go out of favour, but it doesn’t mean they won’t ever do well again.”
For instance, if a ‘value’ manager, who focuses on undervalued stocks, is trailing the benchmark but their performance aligns with other ‘value’ managers, it’s often not an immediate cause for alarm. Kamal Warraich of Canaccord Genuity Wealth Management explains that this could simply indicate that the fund’s particular investment style is temporarily out of favour.
However, Coatsworth cautions against indefinite patience. “If the manager’s style is doing well and the rest of the market is, but they are still not performing, after two years it’s reasonable to reconsider your investment.”
Deeper Due Diligence
When the two-year mark of underperformance arrives, it’s time for a thorough examination of the root causes. Coatsworth suggests investigating whether the fund’s investment process has been altered or if the issue lies solely with poor stock selection.
Key Red Flags to Watch For:
- Managerial Changes: A significant signal to monitor is the departure of a fund manager or the appointment of a new one. Since managers are compensated for their active role in investment decisions, their individual approach directly impacts your returns.
- New Manager’s Background: When a new manager takes the helm, it’s essential to research their history and previous experience. Have they held a prior role within the fund? A promotion from within can be encouraging, suggesting familiarity with the existing processes.
- External Hires: If the new manager joins from another firm, scrutinise how their previous funds performed and whether they managed similar investment strategies. A lack of relevant experience can be a red flag.
- Media Presence and Controversy: A fund manager’s frequent appearance in the press, whether for positive or negative reasons, can also be a cause for concern.
- Controversy: Coatsworth points out, “If you have controversy around an individual, you have to question if you want this person making all your investment decisions.”
- Excessive Praise: Conversely, even consistent positive press coverage can be a double-edged sword. Coatsworth warns, “These managers are in the news because they’ve been doing well. But like with the hype around a meme stock… it may be a sign that it’s time to diversify. You have to question whether a person can continue to be absolutely amazing forever.”
A notable example of a once-celebrated manager facing recent challenges is Terry Smith, whose Fundsmith Equity fund has experienced a decline. Over the past year, the fund lost 5.7 per cent, while the global stock market saw a 14.2 per cent increase. The three-year picture is similarly subdued, with the fund returning just 8.5 per cent against global equities’ 38.9 per cent. While Coatsworth acknowledges Smith’s past success, he notes that a “run of bad luck and consistent underperformance” has tested investors’ patience, though it doesn’t necessarily preclude future success.
Where Active Managers Face the Toughest Battles
In the realm of US equity funds, Andrius Makin, a portfolio manager at Killik & Co, highlights the significant challenge posed by the dominance of the ‘Magnificent Seven’ stocks. These tech giants – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla – collectively represent nearly 33 per cent of the S&P 500 index. Given that US shares constitute approximately 70 per cent of the MSCI World index, with the Magnificent Seven making up a substantial 23 per cent of it, active managers face an uphill battle.
Makin explains, “Nearly a quarter of the MSCI World is in a handful of stocks, so unless you are holding those stocks, it is extremely unlikely that you are going to perform better than the index.” This presents a quandary for fund managers, particularly amidst investor caution regarding the hype surrounding AI and the high valuations of these tech behemoths. Deciding to underweight or omit these stocks risks falling behind if their prices continue to climb, while holding them exposes portfolios to significant downside if they falter.
Opportunities for Active Fund Managers to Shine
Despite the challenges, active fund managers can and do excel in specific market segments. Areas where they have historically outperformed index trackers include:
- Bonds: Fixed income markets can offer opportunities for skilled managers to identify mispriced securities.
- Smaller Companies: Investing in smaller, less-analysed companies often requires dedicated research that passive funds cannot replicate.
- Asian Stock Markets: The diverse and dynamic nature of Asian markets can provide fertile ground for active stock selection.
- Emerging Markets: Countries like Brazil and India, with their evolving economies and less-covered companies, can be areas where professional investors can uncover hidden gems.
In the UK small-cap space, for example, Bestinvest’s data shows that 47 per cent of UK small-cap funds have outperformed their passive counterparts over the last decade. Funds like Fidelity UK Smaller Companies and JPM UK Smaller Companies are cited as top performers in this category.
The Enduring Role of Active Funds
Despite the strong case for passive investing, many believe active funds still hold a valuable place in an investment portfolio. Ennion suggests that managers with proven track records and a consistent investment process are likely to continue delivering superior results. He points to Alex Wright, manager of Fidelity Special Situations, as an exemplar, whose fund has returned 79.3 per cent over five years, significantly outperforming its benchmark of 37.1 per cent.
Makin echoes this sentiment, advocating for a core portfolio built around index funds, supplemented by active funds that offer exposure to areas not captured by trackers. However, Eugene Gorbatikov, an analyst at Morningstar, remains more reserved, stating, “Unless you have strong conviction in an active manager, a passive approach is more prudent.” This underscores the critical importance of due diligence and conviction when selecting active funds in today’s investment landscape.
