OpinionMay 18 2016

Best of both worlds

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Active fund management is under scrutiny like never before. Indeed, seldom does a day now go by without someone – or some organisation – providing research damning the industry for poor performance, under-performance or debilitating charges.

Change, I feel, is a coming.

Morningstar is the latest organisation to pour scorn on the assertion that active fund managers (living breathing ones rather than robots) can justify premium ongoing charges. In fairness, Morningstar has long argued that a fund’s expense ratio is the best predictor of future investment returns. In simple terms, it believes that the cheaper a fund is, the greater chance it has of delivering superior performance.

Its latest analysis supports this conclusion. Scrutinising data for US equity funds over the five years to the end of December 2015, it says that the funds with the lowest expense ratios were three times more likely to generate a high ‘total-return success rate’ (deliver superior performance) than the most expensive. Analysis of other equity classes delivered similar results.

“The expense ratio is the most proven predictor of future fund returns,” said Russel Kinnel, author of the report. “That’s not to say investors should only consider cost when selecting a fund. There are many other variables, but investors should make expense ratios their first or second screen.”

The expense ratio is the most proven predictor of future fund returns

Peter Kraus, chief executive of New York asset manager AllianceBernstein, has also had his say on active fund management. Although his comments were made about the US mutual funds industry, they apply equally to Blighty’s fund management industry.

Speaking to the Financial Times, he said there was a ‘scale problem in the industry’. Funds that reach a certain size, he said, become different investment animals, no longer run to outperform a chosen benchmark but instead managed not to underperform.

In other words, they become less aggressive and more defensive, more akin to closet index trackers. It is a problem that the Financial Conduct Authority has already identified in the UK fund management industry – and is keen to address.

Interestingly, Mr Kraus went on to say that he was perturbed by the amount of money flooding into exchange traded funds, stating: “There is probably too much money in the world today for active. But people are making the illogical leap that they should put all their money into passives. If people realised the risks around exchange traded funds, the behaviour would be much more moderate.”

With this focus on the value of active fund management very much in mind, I recently spent an hour in the splendid company of Rob Burdett and Gary Potter, who have just celebrated 20 years running money on a multi-fund (fund of funds) basis.

Working for a variety of investment houses along the way – Rothschild Asset Management, Credit Suisse, Thames River and now BMO Global Asset Management – Burdett and Potter estimate that they and their team have conducted more than 10,000 fund manager meetings, attended more than 500 UK investment conferences and invested £12bn in funds.

Amazingly, given their utter devotion to investment funds (they will travel the globe if it means digging out a fund gem), the nine-strong team have never suffered a divorce and have even found time to bring up (between them) 16 children.

Burdett and Potter are perfectly positioned to talk about the relative merits of active and passive management.

In light of the fund managers they put themselves in front of, you would expect these best of breed fund hunters to be rabid about the virtues of active fund management, but they are not. Unlike many financial commentators and rival fund managers, they believe investment portfolios should embrace both the active and passive.

“Passives can have an important role to play as part of an overall portfolio, primarily as a means of reducing overall cost and adding diversification,” says Mr Burdett. “At the same time, we recognise that they are destined to underperform the index they are designed to track – a function of fees levied over time and tracking error.”

As a result, the five ‘lifestyle’ portfolios they run (F&C branded) all have exposure to passives, ranging from 22 per cent (‘cautious’) to 27 per cent (‘foundation’).

In terms of picking active funds, they rail against the current ‘cult’ of buy lists which turns advisers and investors into cohorts, holding investment funds that eventually become too big to manage (the argument presented by Mr Kraus), causing performance (relatively) to tail off.

Instead, they prefer to unearth gems – funds that have yet to create a track record but which they believe will come up trumps. It applies equally to their choice of fund management groups. They prefer a left-field approach, identifying boutique investment houses rather than mainstream asset managers (the Findlay Parks and Majedies of this world). Boutiques that devote all their energies to running money.

Of course, not everyone (adviser or investor) can devote the energy and time that Mssrs Burdett and Potter do to hunting active funds that have the potential to deliver alpha. They score funds according to 16 different qualitative factors (for example, assets managed, size and breadth of investment team, investment culture of business and how the managers are remunerated). All time-consuming.

But the fact that they now manage £2.4bn across their F&C multi-manager ‘lifestyle’ and ‘navigator’ ranges (some of it invested in passives) suggests that they are doing something right. And, more importantly, that quality active fund management still has a role to play in a crowded funds marketplace.

Jeff Prestridge is personal finance editor of the Mail on Sunday