If you’re thinking of investing in a fund and are looking for a good fund manager, here are five tips on what to look out for and what to avoid.
1. Look for someone different to the market index.
There is little point investing in a fund that closely mirrors it’s benchmark index (known as a ’closet index tracker’), as most often the fund’s management fees erode returns to below the return of simply investing in an index-tracking unit trust or ETF. In other words, you want to choose a fund manager who is ’active’, meaning he or she does not just replicate the market index but actively pursues good returns.
Some managers ’closet track’ the index out of a fear of failure or lack of conviction about their own investment philosophy. Big basic salaries can dissuade fund managers from taking the risk necessary for better returns. They could lose their jobs or set back their career if they underperform the index. Why take the risk if you are well paid regardless of whether the performance is just ok or very good?
To work out whether a fund manager is sufficiently active, calculate the fund’s active share. This is done by taking the individual share weightings of the fund and subtracting each share’s corresponding weight in the relevant benchmark index. Then take the sum of the absolute value of these differences and divide the result by two. This is a percentage. So for example if the number comes out at 50, the fund is 50% different to the index. As a rule of thumb one is looking for at least a 50% difference. In an SA context, over 60% indicates a high active share.
However, be aware that just because a fund is different to the index (has a high active share), doesn’t mean it is going to out- or under-perform its benchmark index. It simply means the likelihood is high that you are going to get a different result vs. investing in the index.
A viable investment strategy is to have some money invested in an index fund, and some in funds in which there’s a high active share, as this provides diversification benefits.
2. Look for someone who can deliver attractive long term returns at an appropriate risk.
When looking at performance, make sure you are looking at an appropriate time horizon. Be clear as to your own time horizon - how long are you willing to invest for before making withdrawals? For equities your time horizon should be at least five years as shares are a volatile asset class. You don’t want to have to have to withdraw your money two years in when the market may be in a dip. You could be ’selling at the bottom’ and not see the benefit of any recovery later.
Secondly, it is critical to not just look at the return of the fund but also the volatility (i.e. risk) of its returns. At what risk has the fund manager achieved his or her results? Pay careful attention to risk measures such as Standard Deviation, Sharpe Ratio and Maximum Drawdown (these terms are explained well in the factsheet). Be sure to compare these ratios with other funds and with relevant tracker funds (as a proxy for the market). A fund may be achieving higher returns than the market but at a much higher risk. One then has to ask if this higher risk fits your personal risk profile as an investor. Be sure to compare such risk measures over the same time periods between funds.
Maximum Drawdown can be a useful metric to look at as it is easy to conceptualize. It is simply the largest drop (in % terms) from the peak in a fund’s NAV to its lowest point. Compare this number to the benchmark’s number. If it’s 40%, for example, you can say to yourself, I could be in for a 40% knock at some time in the future (if the past is anything to go by!). Or, if the market’s Maximum Drawdown is 40% and the fund’s is only 20%, it shows there is some risk management in place to protect the downside. Be very careful to compare funds over the same time period. A fund which has only been around 2 years is unlikely to have a high MD than a fund which has been around 20 years. The younger fund would not have been around when, for example, the global financial crisis hit and thus would not have suffered that tough period.
3. Understand the fund manager’s philosophy.
Understanding a fund manager’s philosophy is more than just seeing what the fund manager’s positions are with regard to shares in the fund, or a one-liner saying "we are growth fund managers".
Read what a fund manager says he does, and then compare it to what he is actually doing in terms of the positions he’s taking. So you’ll need to understand a little about the shares in the fund. For example, if a fund manager says he only buys companies with predictable earnings, but has resource shares making up 60% of his fund, he is not keeping to his own philosophy, as resource companies by nature have very unpredictable earnings. If you don’t understand a little bit about shares, you won’t be able to make this important judgement.
The philosophy should be evident in the weighting of shares in the fund. No more than 10% should be invested in any one share - more than this indicates significant risk. However be wary of a fund with only 0.5% to 1.5% positions, as this can indicate a lack of conviction. 1% to 6% weighting per share is a happy medium. A fund with more than 40% in a single sector can also be risky. This however is also dependent on the volatility of the sector: 40% in consumer staples is not the same as 40% in resources. History has also shown that managers who concentrate on doing a lot of work on individual shares rather than concentrating on taking bets on macro-economic events tend to outperform.
Besides investigating good performance, look at times of underperformance: did the fund manager stick with his position? Sometimes it is good to change strategy if the facts change, but not if it’s a short-term movement caused by things like minor interest hikes or cuts. Looking at fund manager performance over time is also important. It is very risky to invest with fund managers who change philosophies; they are often the ones who underperform as they don’t have the conviction to stick with their positions. This can be a sign that they haven’t done enough research and work on their positions.
Be sure to check the offshore weighting of the fund. Not all equity fund managers have a mandate to invest offshore, so they can only hold SA listed shares. These managers are clearly at a disadvantage as their investment universe is much smaller than someone who can invest a portion globally. If the fund does invest offshore, check whether they invest directly in offshore stocks, or into a fund. Is this fund their own, or is it a 3rd party’s fund? Check the performance of the offshore fund, and if it is a 3rd party’s fund, whether their philosophy is in line with that of the asset manager.
Finally, make sure you read widely across fund managers. When they talk about a share, compare your own experience of the company to theirs. If their opinions are radically different to yours, ask yourself if this is the fund manager for you. Find someone whose approach makes sense to you.
4. Size can be a hindrance.
Oftentimes the bigger a fund gets, the more it starts to look like the index. There are a few reasons for this. Firstly it becomes harder to buy shares in smaller companies who consequentially have smaller weights in the index (which is weighted according to market capitalisation). This is because in big funds, a purchase or sale by the fund manager could move the price materially; or he can’t take a meaningful stake without buying an uncomfortably large position in the company.
Many fund managers don’t want to own more than 25% of a company due to regulatory or compliance issues. So if a fund manager can’t buy the small-cap shares, he buys the large-cap shares, and this means he can end up looking like the index as it is weighted in favour of large-cap shares.
There is also less incentive to take risks when you are big (and most likely, very profitable). As a fund manager, if you just deliver the index performance, people are unlikely to leave the fund; but if you take a big bet and fail, you could lose half your assets due to withdrawals. Fund managers can therefore become complacent and resistant to change, like any big business. When asset managers are still small, they make a huge effort to outperform the index, but at the same time control for risk by making sure they know what they’re doing, or else their company could go bankrupt.
5. Don’t buy the fund, buy the fund manager.
If the title of the fund has stayed the same but the fund manager has changed, there is a good chance that the strategy has been altered, regardless what the company says. There is a lot of risk when fund managers change, and one has to interrogate any new fund manager’s track record. Fund managers learn lessons as they go along, so someone new to the fund may make the same mistakes as the previous manager did. When a manager leaves the fund, it loses the benefit of all his accumulated knowledge. Continuity is important.
Finally, consider buying into different fund managers in different companies. Always consider choosing one from a small to medium asset management firm as they’re not limited by size when it comes to choosing small- or mid-cap over large-cap shares. There is nothing wrong with including a big fund manager - as long as he’s different to the index, otherwise you are better off investing in a tracker fund.