Even the mightiest funds can fall. No matter how skilful or experienced, all fund managers eventually experience periods of poor performance and as markets shift, no strategy can expect to stay on top forever.
Understandably, when a fund you hold experiences underperformance, it becomes tough to continue trusting the manager with your money. As a result, many investors cut their losses and search for better opportunities elsewhere.
However, Simon Evan-Cook, manager of the VT Downing Fox range of funds, said that this approach reflects a misunderstanding of the goals of active funds, as well as the characteristics needed to be an exceptional fund manager.
He said: “Bad performance is a feature, not a flaw of a great fund. I have never met a great fund manager who did not have a horrendous year relative to the index. You just have to accept it.”
For Evan-Cook, the industry has become too short-term focussed, with periods of underperformance leading to active managers developing bad reputations they do not deserve.
While it is understandable that failure to outperform the index may cause some investors to lose faith, Evan-Cook said it was important to have patience when choosing active funds.
“The hardest thing, even as a professional investor, is the emotional pressure when you see a fund manager underperforming over one, three or five years, to end that pain of holding by just selling off,” he said.
Even he had made this mistake, selling a laggard only to see it start outperforming within a few years when its style returned to favour. “Invariably, whenever I've done that in the past, you end up finding three years later that fund is top of the performance table, winning awards for incredible performance,” he rued.
The aim of active funds is not to beat the index year-on-year but to deliver strong long-term returns, and in this regard, underperformance does not make a portfolio a failure, he argued.
Instead, he believes it should be more concerning when a portfolio has a near-perfect record because this indicates that a manager is doing something unsustainable, such as letting their strategy be dictated by top-down themes.
“If I see a fund manager who has had 10 years in a row where they have outperformed, I’m almost more sceptical about that sort of fund", he added.
How do you identify the best managers?
So, if bad performance is a natural experience for even the best of the industry, what is the ‘X-factor’, that separates perfectly competent managers from the next Terry Smith?
While Evan-Cook admitted that identifying exceptional managers is “an art, not a science”, he believes all the best managers have one thing in common: they are bottom-up investors.
Great managers analyse companies, not megatrends, he said. They look at companies’ balance sheets, valuations, management and competition and use that data to shape their investment decisions.
The best managers constantly reassess their portfolios, identifying companies that are too high risk or overvalued and replacing them with similar stocks that are more desirable, he continued. As a result, they best managers often run a constantly moving portfolio that may have an entirely different stock composition in 10 years’ time, like the classical concept of Theseus’ ship.
Theseus constantly replaced parts of his ship so by the end of his journey, it was made of entirely new parts, leading to the question of whether it was still the same ship.
“We would say yes, it is the same ship”, Evan-Cook said, and exceptional fund management works similarly. “In 10 years, my portfolio may look and act the same, but it will be made up of almost entirely different stocks.”
Index trackers or passive funds cannot match the level of flexibility offered by expert active managers pursuing a bottom-up strategy, he continued.
Moreover, for Evan-Cook, exceptional fund managers have a mixture of belligerent and conscientious management styles, which he described as a ‘bellicious’ approach.
Essentially, the characteristic that separates exceptional active managers from the rest is their determination to stick to their investment philosophy. They will continue to invest in the way they feel is best without being tempted by sudden top-down developments like some of their peers.
Evan-Cook commented: “If you try to push them on their process or philosophy, the greatest fund managers of all time will not move.”
This combination of characteristics is what separates a perfectly competent fund manager from the likes of Terry Smith or Warren Buffett.
Evan-Cook concluded: “It's not that hard to find good fund managers, the real test is holding onto them because there will be years in which the most amazing fund manager looks like an idiot”.