Luck: a fund manager's most profitable strategy
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MoneyWeek editor-in-chief
Merryn Somerset Webb Jan 09, 2012
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What makes a successful fund manager? Is it skill or is it luck? The answer is that it is a little of the first, and a lot of the second.
Managers who do well tend to have a style that works in a particular market. The skill bit is being good at that style. But style is only of use if market momentum is working with it – which makes luck the most important bit.
Take the UK Special Situations Fund run by Fidelity. It has done brilliantly since its launch in 1979. You could put that down to good stock picking. But picking good special situation stocks – abnormally cheap ones, for example – would probably have been of no use whatsoever to the fund’s investors had its launch not coincided with the great bull market of 1980-2000. This was a period in which the market was minded to revalue everything upwards, at one point or another. Over the past five years, the FTSE All-Share has risen 6.9%. In this period, the Fidelity Special Situations fund has returned a mere 0.9%. Bear markets don’t seem to work for the strategy in quite the same way.
The same goes for most kinds of investing. Value investing works where there is value around and the market is in a mood to re-rate it. Growth investing works when there is growth and investors aren’t feeling valuation sensitive. Defensive investing works when the market values security above all else.
Success is really all about momentum. In the end, unless you can change your style continually and at the right time, the odds are you won’t ever have quite enough luck on your side to outperform more than a couple of years in a row.
That’s why so few managers stay at the top. A mere 1.3% of the 2,000 or so funds domiciled in the UK have managed to make top quartile returns (ie, be in the top 25%) in each of the last three years. Widen that out to the top half, and the number is 8.6%. In other words, 90% plus of UK funds are unable to outperform an index for three years in a row. Fund managers tend to look like they are taking turns at being lucky largely because that is exactly what they are doing.
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A good bull market can conceal this basic industry truth pretty well: if a fund is making money, even though it is underperforming, investors tend to be OK with it. But the past ten years have cruelly exposed it: if investors are not only losing money, but losing more than the benchmark, they don’t like it.
Along the way, it has also drawn attention to the fact that, while many fund managers are devoid of much in the way of both skill and luck, they are aren’t half bad at all at making money regardless.
Nigel Legge – once CEO of Liontrust, now of new launch Vinculum Fund Management – has a list of disturbing figures on this subject. In the ten years to 2010, the average equity fund return was 53.8%. But the average investor return after fees was not much more than half of that: 31%. Snapshots like this aren’t fair, but you get the point. Investors pay a lot. Sometimes they get a lot back. All too often, they don’t.
I’ve written about this before but the good thing now is how many new and small fund management companies are being forced into doing something about it.
Terry Smith’s new firm Fundsmith set a welcome precedent with its flat 1% management charge and very low turnover policy (turnover pushes costs up). I also like the structure of the Bedlam Global Income fund: it is targeting a 4.5% yield for its investors but, if it doesn’t deliver, they’ll get their management fee back. That’s a proper alignment of manager and investor interests.
Then there is Legge’s new Vinculum funds. They are to charge 0.25% a year basic. If they outperform their benchmark, Vinculum will take 20% of the outperformance. I totally love the low base fee here. I’m not so sure about the 20% – it is to be calculated every quarter, there is no high water mark, and if Vinculum underperforms, you won’t get rebates from previously-paid performance fees.
Still, at least it’s a shift in the right direction: Vinculum recognises that private investors want change and it is having a go at delivering it.
Also of interest is Vinculum’s investment strategy: it has a model that picks high-quality cash-rich companies and buys them regardless of price. Vinculum thinks that its testing shows this to be a strategy that will work in all circumstances. It might be the first to be right on this (and its research is convincing), or it might not. But I reckon the model should at least work well for the next few years.
Most managers I meet say they are looking for high-quality cash-rich companies to help them weather today’s storm. They’ll not all pick the same stocks, but they’re all on a similar track. There’s momentum there.
• This article was first published in the Financial Times
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