In fact, to a large extent this bias is probably why they are the top performing funds.
The outperformance of the “Growth” style might continue, but it might not.
Either way, there is a risk lurking and the last two to three months have brought that risk into sharp focus with “Growth” underperforming “Value” and the majority of the top performing funds in the IA global sector underperforming Global equity indices.
The chart below is illuminating.
Where data is available we have plotted the performance over the last three months of the top ten percentile of IA Global Sector funds, over the last three years, against the extent of their exposure to the “Growth” style (as measured by “Growth” exposure minus “Value” exposure).
Firstly, almost all of the funds in that group would be considered “Growth” funds (defined by “Growth” exposure of over 30 basis points relative to Global Equity average).
Only two funds, plotted in green, have an exposure below 30 basis points meaning we can consider them ‘style neutral’.
Secondly, almost all the funds have underperformed over the last three months, some very significantly.
The closer to a neutral style exposure a fund has, the better chance of outperformance over the period.
In fact the fund that is very close to ‘style neutral’ is the top performing fund over the last three months (the large green data point).
Interestingly, this fund has delivered three year performance similar to the “Growth” funds, but without the “Growth” style bias and now, since style has changed it has outperformed again.
They say “style never goes out of fashion”, but in investment it clearly does sometimes, and when it does, it provides a ‘learning opportunity’.
So what is a fund selector expected to do to stay in fashion when styles change?
Historically the performance of the “Growth” style compared to the “Value” style has been well correlated with the shape of the yield curve.
Therefore, if one can predict the shape of the yield curve, staying in fashion when the investment style changes is not a risk.
However, it is tough to make predictions, especially about the future, and predicting the shape of the yield curve is no different.
So for most investors investment style risk should be very much of concern.
Naturally the funds of investor interest are the ones with a proven track record of outperformance, but since most of the best performing funds have a “Growth” style, which is the risk we want to diversify, we are not left with many options.
Moreover, since it has been so difficult to outperform without a “Growth” style it does beg the question, how have the funds that have done it, done it?
We highlight three things that do not go out of fashion and can form the basis of solid returns without taking excessive investment style risk.
Firstly, it is worth looking at the potential rewards of concentrating a portfolio.
Most funds have 60, 70 or more holdings, but only 20 stocks are needed to achieve 95 per cent of all the available benefit from diversification.
Moreover, our Monte Carlo analysis of the returns associated with portfolios of varying stock count suggests that for above 40 stocks the probability of an investment result materially different to the average is quite low.
Indeed moving to 60, 70 or more stocks makes only a marginal difference to the probability of a significantly different to average result.
Since there is only a small volatility reduction benefit of above 20 stocks we are left with a ‘sweet spot’ of 20-25 holdings, providing a chance of better than average investment results with acceptable levels of volatility.
It is of course not impossible to achieve the same result with many more than 20 stocks, but the probability is low and for those historical examples of success, an assessment of the similarity of investment style among the stocks held is probably in order.
Such similarities might make the ‘effective’ stock count rather lower than the actual count.
Secondly, it is essential that investors understand the businesses they invest in and focus on business quality not business growth.
Companies that generate sustainably high returns on their capital and return excess capital to shareholders in a disciplined way will outperform over time.
Interestingly the material underperformance of the shares of high quality companies has only happened twice, for any sustained period, since 1980.
It is actually not a feature of the post financial crisis market, as some say, but more a normal state of affairs.
Finally, focus on value. Great companies do not make great investments if the price an investor paid is too high.
As Buffett says “Price is what you pay. Value is what you get.”
These three components are a solid foundation for long term outperformance without exposure to the sometimes hidden style risks that can go out of fashion occasionally.
Tom Wildgoose is head of equity investment at Nomura Asset Management UK (co-manager of Nomura Global High Conviction Fund)
