Two Myths of Fund Management
The fund management industry has a few beliefs that are followed without question. Here are two of them.
Professional fund buyers have rules of thumb; shortcuts that tune out the noise to zone in on funds that (we hope) will work like a dream. But rules of thumb are, by definition, inaccurate. They have exceptions. And where there are exceptions, there are opportunities. Opportunities to make better returns, or take less risk, and often both.
Two such ‘rules’ spring to mind: that funds should have low turnover (i.e. they shouldn’t trade much); and they should be concentrated in a lower number of stocks.
Take turnover. This rule is so pervasive that many fund managers now actively target a low number. I’ve had meetings in which a manager has apologised, like a lapsed adulterer, for higher turnover. ‘It was 72% last year,’ they confess, ‘but normally it’s 25%*, I swear! Just give me one more chance, I know I can be better!’
Meanwhile our obsession with a lower number of holdings — and the assumed link with ‘conviction’ — has more than a whiff of machismo about it: ‘You hold 60 stocks?! Why not 20? Where’s your conviction?’ The implication is clear: more than 30 holdings and you’re a benchmark hugger.
The trouble is, low turnover and high concentration work for some types of investing, but can be counterproductive and dangerous for others. Both can make for highly successful funds though, so by excluding the latter we are missing out.
One fund type in which low turnover and high stock concentration should live is ‘quality growth’. These focus on finding only the very best companies that will, come flood or famine, survive and grow. These are then held tightly, despite the siren song of market noise, with extraordinary compound returns the eventual reward.
Lindsell Train is a successful example: their UK Equity fund owns 28 stocks and has a reassuringly slow turnover in the low teens.
This is as it should be: companies that can withstand the long-term ravages of competition are rare. So we should be suspicious if someone claims to have found a hundred of them in the UK alone. They are also more stable, predictable and often larger. And obviously loading 10% of your portfolio into a large, high-quality firm is usually safer than putting 10% into a small, non-prime company that is more likely to fail.
Similarly, most quality-growth returns are driven by the businesses themselves, rather than shorter-term share price movements. So, if the managers pick the right companies, they shouldn’t need to trade them too often. They can let the company’s own growth do the heavy lifting.
There you have it: for quality-growth funds, a low holding count and low turnover make perfect sense.
But there’s more than one way to skin an index. The perfect complement to quality-growth investing is, I think, value investing. And for value investing, these facets fit less well: I’ve held several successful value funds, and their turnover and stock counts are usually higher than their quality-growth peers.
A value stock’s pay-off profile is different to that of a super-high-quality business. In really deep-value cases, the downside might be a 100% loss if the company goes bust, but upside of 1,000% if it doesn’t. And they only need one of the latter to more than compensate for a few of the former.
That’s an extreme example, and good value managers work hard to avoid business that are about to fold, but you can see how a 10% position might kill their fund if it did. And if three went bust at the same time? End of story.
Such mistakes are more likely in value investing, which is why it works to hold more, smaller positions. The upside can be so large that a 1% position can generate as much ‘bang’ in a year as an 8% holding in a high-quality compounder, but losing 1% of your fund won’t kill you if it goes wrong.
So the holding count should be dictated by the number of opportunities, and the ability of the manager to understand those companies. The latter is constrained by the manager’s time, cognitive load and experience. As such, two managers potentially doubles the number of stocks that can be understood and monitored.
The low-turnover rule also falls down for many value managers. Firstly, turnover can vary with conditions, and in dramatic markets like last year, I expect my value managers to get busy.
And secondly, there’s good turnover and bad turnover. Bad turnover comes from correcting mistakes, while the good stuff comes from selling holdings because their prices have risen too much.
Value managers are, generally, not trying to find the market’s very best companies (although they’re happy to hold them if the price is right). They’re betting that a stock’s price is too low, and that it will soon rebound to a more appropriate level. And the sooner the better: If a share’s price triples the day after purchase, meaning they have to sell it, that’s a great result. It frees up capital for the next idea.
Providing it’s this dynamic driving the turnover, and not cleaning up mistakes, then value managers should be aiming to raise their turnover, not cut it: It implies they’re getting their timing just right, and not having to wait years for the market to notice their unloved stock (whenever I’ve had disappointing experiences holding value managers, it’s always this waiting-for-Godot, death-by-boredom effect that’s undone them, not spectacular stock blow-ups).
For any style there’s a way of checking this: inertia analysis. I’ve recently heard this called, more appealingly, stay-in-bed analysis. It’s exactly that: take your portfolio from, say, this time last year, and compare it to how your ‘live’ fund actually performed. If it underperformed last year’s untouched portfolio, you should have stayed in bed. Or sailed the world. Or built a school in a deprived village. Anything, in other words, that would have stopped you tinkering.
If you’re involved in running an investment portfolio, I’d recommend this exercise. But be warned: it can be brutal. Discovering that you’ve worked hard, and been paid well, to destroy value — when the aim was to add it — is not for the faint of ego. But if you want to improve? There’s nothing more powerful than knowing the truth.
Either that, or stay in bed.
*Turnover is expressed as a percentage. 100% would mean you effectively sold everything and bought replacements once in a year. 0% would mean you did nothing. But 100% could also mean you sold one 5% position in your portfolio twenty times over a year, and left the rest alone. You could also hit 100% despite still holding the exact same list of stocks, if you trimmed and topped them up a lot during the year in response to price movements.