Identify the active funds providing real value-added investing

Managers' short-termism is blighting active funds. Those adding value should stand up and be counted as part of a campaign that could help sort the wheat from the chaff, writes Andrew Pitts.

What must rank as one of the most hard-hitting, thought-provoking critiques of the investment management industry deserves to be widely read by investors and the firms that serve them. 'Let's Talk About Actual Investing' by Stuart Dunbar, a partner at fund management group Baillie Gifford, explains why the investment industry has lost sight of its original goals; why most "active" investment managers are anything but that; and how short-term business priorities and performance measurements are damaging long-term wealth creation.

Baillie Gifford is also launching a campaign to encourage truly active investment managers – not only in the UK but globally – to clearly define their goals and how they aim to meet them. This comes at a time when there is a regulatory onslaught on actively managed funds, which also need to meet the challenge presented by the exponential rise in passive investment strategies.

The outrushing tide of investors into passive underlines the existential crisis that 'active' investment finds itself in. In the eight years to 2017, traditional active strategies have witnessed net outflows of $600 billion, according to the European Federation for Retirement Provision. In the same period, passive strategies have seen net inflows of nearly $1 trillion.

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Dunbar identifies the active investment industry's obsession with short-term gain or loss, regional and sector allocations, or value and momentum, as prime reasons why clients are voting with their feet.

"The main reason why a passive approach has often fared well against its more fundamental rivals is that far too much of what passes for active management is simply second-order trading of existing assets, with the main focus being to try to anticipate the behaviour of other investors," he says.

"This has little to do with actual investing, and it creates huge amounts of over-trading and volatility. It also serves no useful purpose other than for those who make a very handsome living from transactional activity, or those who confuse their clients into thinking that [trading] short-term volatility is skill."

Investors also find it difficult to identify where they are getting value for money. One reason is that the cost of investing has, until recently, been bundled through the entire investment supply chain. Relatively new regulations mean that asset managers are increasingly compelled to separate the costs of management, research, distribution and trading. This might, in time, help investors identify where they are getting value for money, but more needs to be done.

Increasing regulation

A further sign of increasing regulatory oversight is that open-ended investment companies will be compelled to publish an "annual assessment of value" by September 2019 – something that I suspect will leave a great many supposedly active asset managers scratching their heads.

It doesn't help that the short-termism pervading the investment industry today – where success is measured by quarterly or annual goals against a benchmark – is seriously detrimental to long-term returns. Dunbar counters the widely preached mantra that because investors think short-term, the industry has reacted accordingly. On the contrary, he says, "our industry has foisted short-termism on clients in order to manage our own business risks". For such firms, he levels the accusation that "being predictably average is more attractive than being unpredictably outstanding, even when average is worse than passive after costs".

Nevertheless, the author agrees that passive investing has its place, particularly when it is increasingly difficult for investors to identify investment managers who can add real value. As he points out, cheap market access is better value than poor active management.

Some of Dunbar's views are echoed elsewhere. Industry veteran Piers Currie, latterly director of marketing at Aberdeen Standard, says: “The industry needs to move on swiftly from a philosophical discussion of the virtues of active versus passive to addressing the nuts and bolts of how an annual value assessment might be presented in a way that is feasible for fund managers, fair to investors and acceptable to the regulator. With regulators impatient to demonstrate that they are operating in the best interests of consumers, it’s critical to define what we mean by the value of active management – and how it should be measured – sooner rather than later.”

Assessing active share

So, beyond investment firms clearly communicating their ethos, strategies and goals to their clients, how else can investors hope to identify funds that provide them with real value-added investing?

One method is to assess an investment fund's "active share". This is the percentage of holdings in a manager's portfolio that differs from the benchmark index. (A fund with an active share of 0% is effectively tracking its benchmark index.) Some investment funds, but not most, highlight this statistical measure on their periodical factsheets. They should be compelled to do so. It can be a decent indicator of future outperformance, but only when assessed with another critical factor.

Dunbar cites exhaustive academic research showing that the 20% of funds with the highest active share versus their benchmarks outperformed on average by 1.1% a year. That compares with average value-added by all active fund managers of -0.4%. However, the figures for the 20% of funds with the highest active share combined with the highest portfolio turnover tell a more revealing story.

These funds actually underperformed on average by -1.9% each year. But those with the lowest turnover returned an average value-added of 2.3% a year. Taken in the round, this is a further endorsement of actively managed funds that do not over-trade, refuse to bend to benchmark underperformance and stick doggedly to their values and strategies.

Such strategies are many and varied among investment houses and the funds they manage. Baillie Gifford, for example, is very much geared to the future and global thematic trends, and seeks to identify these and the companies that can harness them. It also favours companies that will recycle earnings into potentially profitable research-and-development opportunities.

Dunbar zeroes in on a worrying trend here. "Far too many companies are not investing in their own future because investors are compelling them to take a short-term view." That has resulted in the ratio of investment (capital expenditure and R&D) to payouts (dividends and share buybacks) falling by almost three quarters in the 25 years to 2016.

Fundsmith, like Baillie Gifford, is also a 'buy and hold' investment group. But although it invests in companies with a sustainable competitive advantage, it places more faith in the past as a predictor for the future. For example, the average age of the 28 companies held in its flagship £16.2 billion Fundsmith Equity is 96.

The long-term returns of flagship funds from both groups illustrate the benefits of both approaches. Since launch in November 2010, Fundsmith Equity has returned 285% (its active share is 92%; 2017 transaction costs 0.04%). Baillie Gifford's £7.6 billion Scottish Mortgage investment trust (active share of 94%; portfolio turnover 14%) is up 300%. By way of comparison, their global index benchmarks have returned less than half that.

Baillie Gifford's global campaign seeks to promote firms engaged in ‘actual’ investing – deploying clients’ capital into tangible, sustainable activities, allowing companies to grow and prosper while still generating positive returns for shareholders. The firm says this needs a willingness to be different, and for managers and investors alike to accept uncertainty and the possibility of being wrong.

Assisted by their strong returns, it won’t be a problem for groups such as Baillie Gifford and Fundsmith to meet the challenge of demonstrating how they provide their clients with value-for-money investing. There are, however, plenty of other well-managed funds out there that stick to their investment principles, that sometimes get it wrong, and that have nonetheless fallen behind the benchmarks that have become the widely accepted arbiters of "good" performance.

These funds and the groups that run them need to stand up and be counted before regulators force an 'annual assessment of value' calculation on the wider industry. It will be most unlikely to encapsulate the benefits of value-added long-term investing goals; nor will it better inform clients of firms that pursue such goals.

How passive investors lose out

Investors in passive equity funds face two dilemmas: the risk of falling victim to the cyclical nature of investing following the longest bull market in history; and the potential of missing out on outsized gains.

The accompanying graphic from Dunbar's article, courtesy of research by Professor Hendrik Bessembinder at Arizona State University, tells an amazing story. It shows that the US stockmarket created value (inclusive of reinvested dividends) of nearly $35 trillion from 1926 to 2016, as measured by the excess return from the interest available from risk-free one-month US Treasury bills.

Of the 25,332 companies that existed in that period, just 90 contributed nearly half of the $35 trillion in value created. The next cohort of 205 companies created $8.7 trillion, followed by 797 making up the remaining balance. Beyond these 1,092 best-performing companies, 9,579 (37.8% of the total) created positive wealth in their lifetimes. But this is offset by the wealth destruction of the remaining companies, which represent a staggering 57.9% of the total.

The implication, Dunbar points out, is that just 4.3% of firms account for all of the net wealth creation in the US stockmarket since 1926.

Missing out on those winners naturally results in dreadful underperformance relative to the index. And if you can’t spot these winners, or won't pay a fund manager to find them for you, it makes sense to buy an index tracker. Unfortunately for passive investors, gains from the outsized winners will have been diluted roughly 25 times by the other holdings.

www.bailliegifford.com/actual-investors

The author was editor of Money Observer from 1998 to 2015.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.