17 December 2019
By John Husselbee, Co-Fund Manager HC Verbatim Portfolio Growth Funds
Recent events in the world of fund management will have many long-lasting effects – and one of these, very clearly, will be greater pressure on, and scrutiny of, active managers.
As we have written in the past, the failure of certain very high-profile active managers should not cast a pall over the whole industry or give the passive lobby a free ride. But as long as we can avoid that reductive ‘active bad/passive good’ narrative, anything that helps push up standards and encourages investors to look further than traditional approaches has to be positive.
Given the amount of research dismissing active managers’ ability to add value, it was nice to see a glass half full piece from Essentia Analytics in recent days. According to this analysis, active managers can generate alpha, but they need to work hard to mitigate behavioural biases, typically holding on to companies too long.
Essentia focuses on what it calls the lifecycle of alpha, demonstrating that returns tend to accumulate in the early stages of an investment and decay over time – and managers able to exit positions at or near the peak of their alpha curve can outperform index funds by a margin well in excess of active fees.
With this debate in mind, we were greatly encouraged by a recent meeting with a new team at the helm of one of our underlying funds. Rather than simply quoting a high tracking error and small number of holdings as signs of an active approach, this manager has put a considerable amount of thought into the steps required to outperform – and again, much of that lies in avoiding some of the worst traits that trip up so many investors.
The process begins with four challenges, of conviction, differentiation, fallibility and uncertainty. As stated, these can provide a useful template to identify and avoid behavioural pitfalls, feeding through to principles that help control emotions while not blunting good ideas.
Conviction, for example, is a byword for pretty much any active manager out there but is it about more than just having a focused portfolio? In this case, the answer is very much yes: the manager understands conviction is integral to superior returns but with so much ‘luck’ at play in the market, he believes it is more tenable where preparation precedes opportunity. Doing the research before coming up with ideas is key to this preparation, whereas reversing that and coming up with ideas before doing the work carries a big element of so-called ambulance chasing.
Luck is a dangerous word to use in a fund management context, but this manager prefers to say that a consistent universe, focusing on a small number of companies he knows well and understands, can encourage serendipity.
A second problem to overcome is differentiation, which is particularly important as the active industry works to dismiss the benchmark hugging smears of recent years. This leads to a principle of doing your own thing and avoiding crowds, whether buying or selling, and there is plenty of material on that side of behavioural investing if people are keen to read more – ultimately a crowded trade is rarely a sensible one.
Coming to uncertainty and fallibility, the principles stemming from these are largely around ensuring rigid risk management discipline, both pre- and post-capital allocation.
Before committing capital, the work is about understanding how the manager could be wrong, understanding the position in full and ensuring there is a sufficient margin of safety if anything does go wrong; post-allocation, it involves what the manager calls torturing the portfolio, understanding and responding to data points as they come in.
Key to all of this is a basic situational awareness, maintaining intellectual and emotional honesty on the risks in the portfolio and why they are there. Overall, this blend of what the team believes to be superior ideas with superior discipline creates a process insulated as far as possible against common wealth-destroying mistakes.
Other managers will have their own versions of this and there is no ‘right’ system – what this does show however is the amount of time and effort required to prove their value against peers and cheaper passive options. The days of mentioning conviction and tracking error a few times in a presentation and considering that a job well done in terms of active ‘proof’ are gone.
As our investors will know, a key mantra behind our process is that while consistency of performance is ultimately impossible for fund managers over every time period, consistency of process is a must for all those we select. As we said at outset, anything that helps us understand the motivation of managers – especially given how fall into common behavioural traps – can only serve to help us in our job sifting through the thousands of funds out there to find the optimum blend. In the current ultra-critical environment for active managers, the luck versus skill question has to be addressed – and will be a topic to which we plan to return in future articles.
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