We are bottom-up stockpickers. We don’t do macro.’ This is a mantra we hear fairly regularly when listening to equity fund managers talk through their philosophy and process.
Taken on its own, this sounds absurd. How can you analyse any company unless through the prism of the economic backdrop? The business cycle, the interest rate cycle, currency movements, and so on – they all have a meaningful bearing on company earnings and, therefore, ratings and share prices.
What these managers really mean is that they don’t make macro bets in their portfolios that trump the bottom-up analysis. Essentially they can take the consensus or house view on issues such as growth and inflation expectations and then focus on the stock-specific factors.
When we are on the other side of the table talking to potential investors in our multi-asset funds, we are often asked about where most of our returns have come from – asset allocation or fund selection. The answer is undoubtedly asset allocation and we expect that to be the case going forwards.
But should returns from asset allocation and fund selection really be looked at as distinct? Isn’t fund selection primarily also an asset-allocation decision? Just as we make calls on the relative merits of equities versus bonds, Japan versus Europe, high yield versus investment grade, primary versus secondary property, sterling versus the US dollar, we also skew our equity weights towards certain styles and factors.
We ask ourselves the same questions about the merits of value versus growth, large versus small caps or momentum versus quality, often based on the macro. And because we have collectively been analysing funds for a very long time, we know which managers exhibit those distinct styles. We also know where managers lie on these style spectrums from deep value to speculative growth.
Providers of exchange-traded funds have been quick to roll out products that seek to capture many of these styles but, while we will use them sparingly, they are by no means going to replace the active managers in our portfolios.
While managers might exhibit a style, there is genuinely more to the top managers than just a style tilt. Passive approaches that focus on styles or factors are, by their nature, more one-dimensional than most active approaches. This is most evident in how valuation agnostic they will be – an active manager might balk at paying extreme multiples for in-vogue stocks, even if they exhibit many favourable characteristics.
Meanwhile, value strategies find it hard to avoid value traps, where even bottom-up stockpickers might have identified the impact that a slowing China would have on mining stocks and avoided the sector altogether.
It is these elements of fund analysis that go beyond the macro or style call and make fund selection a distinct skill. It is about knowing how pragmatic managers are or how wedded to a style they are. It dictates whether a manager is right for a medium-term tactical position or someone to buy and hold over the very long term.