How to pick a winning fund

published 23 February 2018

884-Salmon-634 — Managers that can swim against the current are rare

Beating the market is about choosing the right fund managers and timing. Both are tricky. You might be better sticking with a tracker.

At MoneyWeek, we often highlight the merits of index tracking. It's cheap, it's easy, and you know you'll get the return on the market (less costs), which is better than the majority of active fund managers (who try to beat the market rather than simply copy it, like a tracker) can achieve. But what if that's not enough? What if you are determined not just to beat, but to trounce the market?

That's what Ben Inker at US fund manager GMO looks at in his latest research note. Say you are picking funds for your pension portfolio, and only the very highest long-term returns will do. Clearly, the first thing you have to do is to choose managers whose investments differ greatly from the benchmark.

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After all, if you want market-beating results, you have to do something very different to the market. That means opting for managers who run concentrated portfolios (so not too many stocks) with "high-tracking error" (their returns don't just move up and down in line with the underlying benchmark).

The problem with choosing managers

The obvious problem is how to pick these managers. Taking the opposite view to the market might bring huge rewards, but also runs the risk of big losses. Yet on that front, Inker isn't too worried. He reckons that as long as you invest in a range of managers 20 based on the assumptions he uses then even if three-quarters of them fail to make the grade, the aggressive portfolio should still win out.

The real but less obvious risk is timing. Investors have an unfortunate tendency to buy at the top after a period of outperformance, then sell at the bottom after a manager has underperformed for a few years. That might not matter, but even high-quality fund managers suffer from periods of underperformance because investment styles go in and out of fashion.

Inker points to a 2011 study by Aaron Reynolds, from the AAII Journal, which looked at 370 funds that had beaten their benchmark over ten years. Even during that period, more than half had lagged the benchmark by at least 3% per year for a period of three years. And these were not especially aggressive funds, so more concentrated, contrarian funds would almost certainly suffer more painful downturns.

What can you do? The ideal solution is to find decent managers after they've endured a period of underperformance, then buy in and sit back. But in the absence of perfect foresight, you need to control your own worst instincts and hang on through the inevitable downturns, only selling if your rationale for backing your carefully chosen fund manager changes. If you're not confident of your ability to do that, then stick with a passive portfolio.

I wish I knew what a closet tracker was, but I'm too embarrassed to ask

Tracker funds (trackers) invest in a basket of shares (or use derivatives) to mirror an underlying index (such as the FTSE All-Share). Index funds don't employ professional managers to decide what stocks to buy, so there are relatively low fee charges. The index fund will always underperform the market slightly after costs, but you can be fairly confident that it will otherwise be able to track the market.

Active funds do the opposite they charge higher fees and employ stock pickers in the hope they will beat the market and thereby justify their higher costs (although often they fail to do so).

However, in some cases, an active manager picks a portfolio that is little different to the overall market. These funds are"closet trackers" and represent the worst of both worlds: they charge high active fees, but deliver a passive return. There are many reasons why managers do this, ranging from laziness to the fear of getting fired.

There are ways to spot a closet tracker. An obvious method is to look at its historic performance and how much it differs from the wider market. One key metric to consider is the active share. This compares how significantly a fund's portfolio differs from its benchmark index. The higher the score, the better.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.