What’s the best way to run a fund?
I’ve heard thousands of investment philosophies and processes. Which is the best?
Cutting my hair, rewiring my home, and investing my money in individual shares — all things that should be done by someone who isn’t me. Which is why I use trustworthy, experienced professionals who care about results. But only for the third — buying shares — do I occasionally daydream about doing it myself.
That’s today’s question. Having interviewed hundreds of fund managers, how would I manage an equity fund myself? Which ideas would I nick, and which would I leave on the shelf?
What’s the point?
First, it’s important to understand what my imaginary fund is for. It’s amazing how many fund managers can’t explain this — it’s not a good look. I want it to make high total returns, but I also want it to be ‘usable’. Too many funds fail to account for what their holders want, and what journey they can realistically stomach. Fantasy or not, a fund won’t last if it gets this wrong.
One target I commonly hear from great managers is to average a total return of 15% a year over the long term, which means doubling your money every five years. In fact, I hear it so often I wonder if it’s being taught somewhere. Regardless, I like it, and I’ve held funds that have achieved it. So I’m going for it too.
My return relative to the market will, therefore, depend on what the market does. But let’s say I’d like to beat it by, on average, 5% a year. If it’s a percentage point or two either side of that, I doubt there’ll be complaints.
Global or single market?
A previous employer once ran an advert for a global fund with the tagline: ‘Why fish in a pond when you can fish in the ocean?’ To which I thought: because fishing in a pond is easier, safer, and cheaper (pointing this out didn’t go down well with our marketing chief).
It wasn’t just smart-Alecry, it’s a serious point. A global manager benefits from wider choice. But perhaps there’s too much choice. Where would I start? And would I spend too much time finding ideas, and not enough analysing and exploiting them?
Plus, are there too many moving parts?
Running a UK or US fund isn’t easy, but at least I wouldn’t have to worry about extra trip hazards such as country, regional or currency selection. I’d also worry about being a Jack of all trades. Could I sniff out and stay on top of a Japanese small-cap opportunity better than a dedicated, local specialist? I’m not convinced I could.
None of this is to knock global funds — I own plenty and they’re doing a cracking job. But in my fantasy equity fund I’m opting for my simple British pond — unloved as it may currently be — over a more challenging life on the global seas.
Unlike geography, when it comes to company size I’d want free range. So it’s an ‘all-cap’ fund for me.
But a proper all-cap fund, not one of the many that are shaped like market trackers (mostly large-caps, a few mid-caps and a seasoning of small caps).
Think about this statistically. Markets are like jungles, there are a handful of elephants, many more monkeys and swarms of mosquitoes. So, if you’re genuinely trying to find the best opportunities, do not hug a benchmark. That there are so many more small than large caps means they should, theoretically, make up most of your fund.
Small caps also have more room to grow than large caps and are more likely to be mispriced by the market. This gives a good manager scope to make more money. This is, after all, the point of the exercise.
So, being focused on the size of the money-making opportunity, and not the benchmark, my fantasy fund is likely to have a heavy bias to small and mid-caps.
This will make the ride a little bumpier for holders, so I’ll have to flag that clearly upfront, and consider sliding in a couple of hand-picked large-caps so as not to scare my holders too much when small caps are struggling.
Bottom-up versus top-down?
No doubts here: bottom-up. There’s a long list of stock-picking legends (Buffett, Lynch, Bolton etc), but, despite plenty who’ve tried, I struggle to name any managers who’ve enriched their investors through top-down decisions. And with good reason — timing markets, themes or industries is all but impossible to get right on a regular basis.
So, while I might consider the impact macro factors may have on individual companies, I don’t play unwinnable games, so dictating the fund from the top-down is off the cards.
The two styles I’ve seen succeed most over my career have been ‘value’ and ‘quality growth’, and I’m a big fan of both. But the funds that have really excelled for me often combine the two.
This means starting off by assessing the quality of the business, with a view to finding a longer list of, let’s say, 60 companies that can survive all that life throws at them and still come out growing. Clearly, the devil is in defining quality. From what I’ve seen here, the qualitative factors are just as important as crunching the numbers, making this stage of my fantasy process part science, but mostly art.
This is where I consider ESG. My definition of quality excludes poorly-managed companies with weak cultures that are up to no good. Beyond that, I’ll make up my own mind about what’s good or bad, and not outsource my conscience to a faceless third party.
But finding great companies isn’t enough. I agree they can be poor investments if you pay too much, so valuation matters too. That’s why, from my longer list of 60 companies, I’m only holding the 30 cheapest at any given time.
Rotating between them as prices shift will raise my turnover but, in this fantasy, the value from avoiding gravity-challenged share prices dwarfs any extra trading costs.
This sits my portfolio in the tiny crossover on the Venn diagram circles of ‘high quality’ and ‘cheap’. But, I only need 30 of them, so this isn’t an impossible dream.
And then there’s momentum, something I’ve come to respect more over the years. I’ve seen too many value managers derailed by stocks whose cheapness outlasts their fund holders’ patience, so I’m using my capacity-controlled, nimble portfolio to hold off buying till there are signs the market likes the stock as much as I do. There’s nothing better than a cheap stock with positive momentum, so I’m filling my make-believe fund with as many as I can.
Will my process be the industry’s best performer?
Probably not — I’d expect a dedicated small-cap value manager to beat me. Those things fly when they’re run well and right-sized, which is why I always try to hold a few in my portfolio of funds (see Fidelity’s UK Smaller Companies fund, run by Alex Wright then Jonathan Winton, for a good historical example, while Cape Wrath UK Equity is one playing that role for me today). They’re labour-intensive though, and difficult to scale, so for an easier life I’m steering clear of that particular fantasy.s
Rest assured, this will remain a dream for me. My hard-won skillset is buying funds, not stocks. And having seen the experience, knowledge and x-factor that’s needed to beat the stock market, I’d sooner cut my own hair than pick my own shares, so I’m leaving it to the pros.
Everything expressed here are my opinions only, and should not be taken as investment advice. This article first appeared in Citywire in May 2023.