Finding the right money manager can be like looking for a needle in a haystack. The following should help to narrow your search down.
1: The Fund Manager
2: Skin in the Game
3: Long-term Historical Performance
4: Concentrated Holdings
5: Low Turnover of Stocks
6: A Fund that has not Grown too Big, or is too Small/Illiquid
ONE: The Fund Manager
'It's impossible for you to produce a superior performance unless you do something different from the majority.' Sir John Templeton
This quote by the legendary fund manager effectively says that if you are looking for someone to invest your money successfully, you need a maverick manager.
It stands to reason that the few money managers who are able to outperform their benchmarks over the long-term, after fees, are not going to achieve this by doing the same thing as everyone else. You also need to have confidence in their stability – that they are maverick yet also dull and dependable within that, and so are able to be consistent over the long-term.
There are also external factors which can affect a fund manager's performance. You must try and keep an eye on these as best you can. These include:
a: The company they work for
The fund manager's company is extremely important as:
1: If it is not a good place to work, the fund manager may not be happy and their performance may suffer, or they may leave.
2: The culture of a company affects its employees. You want a culture which looks to align the interests of its employees with its clients.
Boutiques vs Big Firms
In fund management, the comparison of the two types of firms is like David and Goliath. In terms of public awareness, the Big Firms have it all via their all-conquering marketing and sales departments. The average private investor just hasn't heard of most boutique firms. However in performance terms, a number of boutique funds have superior long-term performance figures to many big firm funds.
Favourable attributes associated with boutiques include:
1: Managers who think independently
2: A lack of benchmark-hugging
3: A reasonable, incentive-based remuneration
4: Less run by committee, meaning decisions can be made quickly
5: Less bureaucracy and company politics to deal with than at big firms
6: Higher level of employee ownership and investment in own funds, aligning employee and client interests
7: Lower staff turnover
The downside of boutiques include:
1: Individual funds tend to be very much 'owned' by their manager, so if that manager does leave, or dies, they are very hard to replace.
2: They can be capitally under-resourced, so in the event of a big economic downturn, they may struggle dealing with a large amount of redemptions.
Funds run by founding partners of boutiques are especially appealing as there is a greater expectation that the manager will be there for the long-term. Bear in mind that most funds are run by a team, and it is equally important that the team has been together for a long time.
Big firms tend to have 'lowest common denominator' stuff to deal with e.g. a focus on 3-month performance for clients, internal politics, personality clashes and the terrible dilution of ideas which can arise from committee meetings.
If a large company has a 'hot' fund manager with a great recent performance, a further problem is that the marketing team will want to wheel them around the financial press for interviews, and make presentations to institutional clients. If you are a focused fund manager, this sort of thing may act as a distraction to your work, and your extra work commitments may lead to your fund performance suffering.
It is certainly true that if you go through the financial press archives, you will find that a lot of young fund managers heralded as 'ones to watch' have not lasted that course.
This is not to say that all large fund management companies are bad, and all boutiques are good. Generally speaking, the culture at boutiques works more in favour of clients than the big firms, but there are some terrific funds at the big firms – ultimately you need to study each fund in turn and decide on their individual merits.
Finally do not pay any attention to the fund's name, as this has probably been conjured up by a marketing wonk to appeal to whatever investment 'trend' is the flavour of the month.
b: Personal factors
Has the fund manager recently suffered personal problems? A messy divorce, or personal tragedy may mean they are not concentrating on their work, and the fund's performance may suffer.
This might sound absurd, but great fund managers are incredibly rare. Think of them as the goose which lays golden eggs. If their health is suffering, you really need to know about it, or there won't be any more eggs.
Unfortunately this information is usually hard to obtain, but if you know any 'insiders', do ask them to let you know about anything relevant.
TWO: Skin in the Game
One of the most important factors when investing is to ensure that the fund manager's interests are aligned with yours. There are two main ways of ensuring this. One is that the manager invests their own money in the fund they manage for you. The second is that they are stakeholders in the company they work for.
Le patron mange ici
Another advantage of Investment Trusts is that the fund manager and the trust directors can (and should) hold a number of shares in the Trust themselves. You can see how many shares each of them hold in the Trust's Annual Report. A manager who is confident in their abilities should be happy to invest their own money in their own fund, just as the phrase Le patron mange ici is the classic indicator of confidence in a restaurant's food.
An extreme example of this is the Jupiter European Opportunities Trust. Alexander Darwall has been the manager of the Trust since November 2000. He currently holds over 4 million shares in the Trust, meaning that his performance will have a very material effect on his wealth. It should therefore be less of a surprise to discover that if you had invested £1,000 in the Trust 10 years ago, it would now be worth £5,281, one of the best performances over the period (an investment of £1,000 in an ETF tracking the FTSE All-Share index meanwhile would be worth £1,686 over the same period. (n.b. Figures taken at 31/10/13)
You would not normally expect a fund manager to have all of their wealth in their own fund; just like yourself they may want to diversify their investments, but if they have shares worth over £500,000, you can feel pretty comfortable that they will not be complacent about their performance.
The John Lewis Partnership
We saw earlier that one of the reasons for the success of John Lewis is its ownership structure, and the fact that all the employees have a stake in the company. Consider a small family partnership. Each of the partners have a substantial stake in the firm, and the employees also have a small stake. They have a direct incentive in the long-term success and stability of the firm. They do not have the money for a marketing budget. Instead their work speaks for itself. This all means that they have multiple interests in making sure their clients are satisfied.
In contrast then think about a big bank. Most employees don't have a stake in the firm. They do their job competently, but have no incentive to go the extra mile to help their clients when necessary. It may be quite the opposite – that they are motivated by commission from selling new products to their clients. This means that they have no interest in considering whether the new product is of any use or interest to an individual client.
At this same company, there are also the bigwigs at the top. They are awarded options in the company for achieving certain targets. These targets can often be achieved by the bigwigs turbo-charging the short-term performance of the company at the expense of long-term performance. This does not concern them as by they've cashed in their options and the company is starting to show its cracks, they will have moved on to another company.
THREE: Long-Term Historical Performance
You want to know the fund manager's record over the last 10 years (or ideally 14 years, so you can see how they coped in the 2000-03 bear market). How did they cope in different market environments such as the tumultuous period of 2007-09?
You are looking for a fund manager with a clearly defined and consistent investment philosophy. You will never be 100% certain if a manager's good performance results from talent or luck, but if you know how they invest, you have a better idea of whether historically their actions aligned with their performance.
When looking at the best fund managers, some will outperform when markets go up, and others will outperform when markets go down. It is extremely rare to find managers who can outperform in both scenarios.
Remember that an ability to preserve capital in a bear market is generally a more important skill than outperformance in a bull market, as if you lose 10% of your money, you have to then make more than 10% to return to what you originally started with. But if you consistently make a 5% return every year, over 10 years you will do much better than most people who have gone up 20% some years, and down 20% other years.
An investment adage is that you should not 'confuse brains with a bull market', a version of the quote, 'a rising tide carries all'.
There will always ultimately be a question mark over whether a fund manager's performance is down to skill or luck. This is why the statement attached to every investment advertisement, 'past performance should not be seen as a guide to future performance' is so important to remember.
Since you can never be sure about a fund manager's ability, your trust in them is the best measure you can rely on. The next best guideline is if they have a strong record in diverse circumstances over 10 years.
Almost no managers, even the best, can outperform their indices in both bull and bear markets. You are looking for managers who have a consistent, definable style so that you have a reasonable idea of how it will perform in a particular economic environment.
Once you know this, you can boil down each manager to being like a particular 'tool' in your 'portfolio box'. Since you are trying to build a portfolio that can perform without you knowing what's going to happen in future, your portfolio should contain a variety of tools i.e. some managers who outperform in bull markets and others who outperform in bear markets.
Your preferred funds, though, will be the ones with lower downside volatility i.e. their managers protect are able to protect capital to a certain extent in bear markets.
The website Morningstar is useful for performance statistics – shamefully many other websites only list performance figures for up to five years.
Five year figures at early 2014 were a classic case of 'lies, damned lies and statistics'. Early 2009 was pretty much the bottom of a very distressed market. The markets have mostly been going up ever since then, and so the 'best' funds on a five-year basis are the most aggressive ones in a rising market.
You will therefore see no evidence of how these aggressive funds performed when things went downhill (usually it is pretty badly). Ten year figures in contrast offer a broader picture of how they coped during the credit crunch.
Of course you also have to check that the current fund manager has been managing the fund for 10 years (or the fund has existed for 10 years), as otherwise the statistics are irrelevant. This information is usually available on the factsheets most funds produce each month which can be downloaded from their websites.
FOUR: Concentrated Holdings
You should be looking for funds which have concentrated holdings i.e. ideally less than 50 holdings, and a low turnover of holdings. One of the great travesties of investing is that the OCF (the figure which specifies a fund's annual expenses as a percentage of the fund) does not include dealing charges.
Many funds, particularly those with a large number of holdings, are frequently buying and selling stocks. This can create significant extra charges which detract from the fund performance (some independent research has suggested that every 10% of annual stock turnover adds a 0.1% to the OCF. However it is difficult to monitor these 'hidden' charges unless you are able to access the fund's annual report (this is much easier to do with Investment Trusts than Unit Trusts and OEICs.
Examples of funds which do things the right way are Lindsell Train UK/Global Equity and Fundsmith. It is perhaps no coincidence that both funds are independently-owned by their founders and small enough to be called 'boutiques', meaning they are able to make independent decisions without the dilutive interference which arises from large board meetings at larger companies. In addition the managers have large stakes in their own funds.
The managers of both these funds like to cite a study by some terribly clever academics which shows that once you have about 25 to 30 holdings in a fund, there is a massive diminishing return in diversification if you add any more.
The other argument for a fund with concentrated holdings comes from Phil Fisher, one of Warren Buffett's favourite investors. In riposte to the old adage, 'Don't put all your eggs in one basket,' Fisher prefers the Mark Twain quote, 'Put all your eggs in one basket, and... watch that basket!'
The theory here is that fund managers who own 100 companies in their fund do not have enough time to be able to know all of them inside out and keep up-to-date with their news, and even more so if you replace a quarter of them every year. In contrast, if you have thirty companies in your fund, and you've had them all for five years or so, you will have a pretty good feeling for any warning signs or improvements in their performance.
FIVE: Low Turnover of Stocks
There are a few reasons why you should favour funds which rarely make changes in their portfolio.
Firstly there is the issue of cost. We saw above that every time a fund manager buys and sells a stock, they are paying a fairly hefty broker's fee. This cost is then passed on to you.
Secondly is the point made connected with the concentration of holdings. The longer a managers holds a stock, the better they should know the company and any peculiarity in its business cycles. This means that they are much better suited to recognising any warning signs in the company performance, know the impact of any key personnel leaving, and are not worried if earnings over a cycle are 'lumpy' rather than the perfect, consistent increases in earnings that managers with a more short-term outlook prefer.
A third benefit is that compound interest is more likely to work with you rather than against you, through the compounding of increased dividends and retained earnings.
A brief note on dividends. The issue of whether it is better for a company to pay out dividends or retain earnings is yet another long-running 'religious' argument. It partly depends on the type of company, as it is naïve to think that a new and fast-growing business should be expected to pay dividends to investors rather than reinvesting in further growth.
A key pro-dividend argument is that paying a small dividend, which increases annually above inflation, can be a good discipline for a company. It is also popular with investors, both for the money received and the demonstration that the company's profits have increased and are healthy enough to be able to afford the dividend. Directors would be foolish to raise dividends if they do not believe that their next few years' earnings will be able to pay for them (though of course some Directors are foolish.)
The anti-dividend argument applies primarily to someone who is investing for the long-term in a well-run, smaller, growing company. The idea is that good company managers should be able to use the profits (i.e. retained earnings) and invest them wisely in growing the company and increasing its profits further, which in the long run will increase the value of the shares. This is also much more tax efficient, as dividends paid to the investor will be taxed at a minimum of 10% and quite possibly 32.5 or 37.5%. The miracle of compounding means that reinvesting retained earnings without losing 32.5% in tax over a number of years can be really quite impressive.
This does not apply so much to mature, defensive companies, which are highly cash generative, and are so big they no longer have much opportunity to grow. Companies like this are more likely to pay high dividends and be the mainstay of 'Income Funds'.
Incidentally one of the occasional joys for the long-term investor is holding a successful dividend-paying company and realising that after many years the annual dividend has increased to the extent that it is now equal to the amount you originally paid for the company.
SIX: The Popularity and Size of the Fund
Warren Buffett wrote a letter in 1975 advising a client the best way of managing her company's pension fund. One of his preferred methods was a money manager... 'handling small amounts of money whose record is good for the right reasons. Then hope that no one else finds him'. Buffett believed that above-average performance could not be maintained with very large amounts of money.
For funds, size is a problem that generally only applies to Unit Trusts and OEICs, and is highly unlikely ever to apply to an Investment Trust. This is because a Unit Trust gets 'bigger' every time you buy units in it, while the shares you buy in an Investment Trust do not affect the size of it.
Throughout the past 50 years, there have occasionally been Unit Trusts and fund managers which have stood out from the rest. After a while, their superiority was so glaringly obvious that more and more people invested in them. They became bigger and bigger and bigger.
This leads to a fundamental problem of the structure of Unit Trusts and OEICs. Let's say it is 1999, and you have read about an amazing Unit Trust specialising in Tech Stocks. The fund has gone up by 50% in the last year alone. You make an investment and buy some units in it.
Your action means that the Unit Trust has grown in size, and the money you put in is used to buy more Tech Stocks. The problem is that Tech Stocks are now really expensive and it's really not the time to be buying them. But a Unit Trust has no choice in the matter. And since everybody knows what a great fund this is, there are lots of people just like yourself, effectively fuelling the tech stockmarket bubble.
There is a separate problem when Unit Trusts get REALLY big, although this applies more to funds investing in more illiquid asset types, such as Asia and Latin America or Smaller Company Stocks.
Consider a successful fund investing in Vietnam. The fund holds stocks of 50 different companies, which are the best there are in the country. If the fund manager suddenly has lots more money, then they could keep buying more of the same companies. But there is the danger that they would own so much that they would be the controlling shareholders, and fund managers generally don't want to get involved with owning companies.
The alternative is to buy shares in a new company. The problem is that the fund manager already owns stocks in all the companies he likes. This new money means he will have to buy stocks in a company he is less keen on, and accordingly which will are likely to make lower returns.
The inevitable consequence is that the more popular a fund becomes, attracting more money, the worse the performance becomes, as shares in another, inferior company are added.