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6th
Dec
2021

“Don’t look for the needle, buy the haystack!”

Markets Make Managers

Being in the right place at the right time in all walks of life can have a remarkable impact on outcomes, but this generally occurs by chance. This is no less true than in the investment management world.

Most fund managers have a view on how markets work – and their own skill sets – that they weave into an investment philosophy to guide them through the portfolio choices that they make. The fund management universe can be divided up into a wide array of approaches. Some will believe that markets get prices wrong, which can be exploited; others believe that markets work quite efficiently, incorporating information quickly. Some may wish to own concentrated holdings; others prefer broadly diversified portfolios. Some see companies that are growing fast to be a source of strong future returns; others will see value in buying companies that are cheap relative to some fundamental metrics like book value, cash flow or earnings. Due to this wide variation in styles, inevitably, some will be in the right place at the right time, more by luck than judgement, in any short-term to medium-term period.

Over the longer term, however, academic research and empirical evidence suggest that a diversified pool of ‘cheaper’ companies are likely to outperform rapidly growing more ‘expensive’ companies[1]. It also suggests that broad diversification provides a greater chance of capturing the market return, than a poorly diversified concentrated portfolio[2].

To illustrate this point, we plot below all of the GBP-based, actively managed equity funds that hold less than 150 companies in their portfolio. Each column represents a bucket of funds that delivered a specific level of annualised returns over the past five years.

Figure 1: High conviction active funds (1,855)[3] – five-year distribution of outcomes

Markets make managers

By definition, these professionals all believe their style to be ‘right’.

The first point to note is that the global equity market (sitting in the yellow bucket), which could be accessed through a cheap index fund, beat just under 80%[4] of all these active managers, who were no doubt well-rewarded for turning up each day.

It is also evident that large US companies that exhibit growth characteristics – as represented by the US large cap growth index in the red bucket – have performed spectacularly over the past five years. Managers with a growth style will have been picked up and washed ashore by this huge market wave, which has largely been driven by the increasing multiple that investors are willing to pay for each $1 of a given fundamental measure, such as book value, cash flow or earnings of a company. That is not something that fund managers can control. Perhaps not surprisingly, 70% of all funds that beat the global equity market were classified by Morningstar as having a growth-oriented style[5]. Markets make managers.

If one had the power of foresight, owning US growth stocks in a diversified manner through an index fund would have beaten 1,799 of 1,855 active funds reviewed over the past five years and delivered a handsome return. On average, they doubled in value around every three years over the period under review, which is an extraordinary rate that is well above average and unsustainable. It takes a good dose of hubris to claim that anyone could have foreseen the massive expansion of multiples we have seen (i.e. these stocks have become more expensive), let alone been able to pick the right highly active manager. The low odds of trying to do so are evident from the chart and the data provided.

Today, growth stocks are more-or-less as ‘expense’ relative to ‘cheaper’ value stocks as they have ever been[6]. In five years’ time, the waves may well wash up another small set of active managers with spectacular performance with a different style. Long-term investors do well to look beyond the ebb and flow of the waves on the shore to the more stable horizon of broad market returns. As Jack Bogle, the founder of Vanguard used to say:

‘Don’t look for the needle, buy the haystack!’

—-

[1]     Fama, E., French, K., (2015) ‘A five-factor asset pricing model’, Journal of Financial Economics, 116 (2015) 1-22.

[2]     Wei Dai, PhD, (2015), ‘How Diversification Impacts the Reliability of Outcomes’, November 2016 – Dimensional.

[3]     Funds with GBP base currency, >80% equities, closed-ended, open-ended and ETFs with <150 stock holdings.

[4]     This does not include any funds that started the period that may have closed resulting in ‘survivor’ bias in our numbers.

[5]     Using Morningstar’s style box analysis.

[6]     https://www.aqr.com/Insights/Research/Webisode-Are-Value-Stocks-Cheap-for-a-Fundamental-Reason

Helen Learmonth
Financial Life Planner – WealthFlow
helen.learmonth@wealthflow.com

 

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Errors and omissions excepted.

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© 2022 WealthFlow Group Limited
All Rights Reserved | Privacy | Cookies Policy

Head Office & Consulting Rooms: 10 Charlotte Square, Edinburgh EH2 4DR.

Mail correspondence to our Central Scotland Admin Hub: WealthFlow Group Limited, PO Box 14947, Grangemouth FK3 3AU.

Authorised and regulated by the Financial Conduct Authority

For your protection, unresolved complaints can be referred to the Financial Ombudsman Service.

Registered in Scotland No SC635011. Registered Office: 10 Charlotte Square, Edinburgh EH2 4DR.