Contrarian investing profiting from out-of-favour assets isn't easy. In an extract from his book, The Sceptical Investor, John Stepek looks at how to find fund managers who can do it.
Finding a fund manager who can outperform the market on a consistent basis over the long run is not easy. Indeed, one of the main arguments for passively tracking the market over active investing is that it's so hard to find good active managers. That said, there are ways to boost your odds. Here are some key traits to look for if you're trying to find a contrarian manager.
A transparent, clearly communicated strategy
Look for managers with defined strategies that they can easily articulate. Successful investment is tricky, but the principles are not hard, so it should be more than possible for a knowledgeable fund manager with any degree of enthusiasm and conviction to explain their process to a reasonably intelligent adult.
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Understanding how a fund is "meant" to work is critical. David Swensen who, as manager of the Yale University endowment, has access to the most elaborate investment strategies on earth has said in the past that he is not a fan of "quantitative" strategies, which rely on algorithms to find patterns in markets. "The fundamental reason is that I can't understand what's in the black box. And if I don't know what's in the black box and there's underperformance, I don't know if the black box is broken or if it's out of favour. And if it's broken, you want to stop. And if it's out of favour, you want to increase your exposure." Swensen's point is that you need to be in a position to judge whether a manager's strategy makes sense; whether it fits with your own portfolio; and whether the manager is actually sticking to it. "Style drift" is probably one of the biggest risks to watch out for with active funds, because if you think you own one thing, and in fact you own another, it can derail your whole strategy (look at Neil Woodford, for example).
You probably won't be able to talk directly to a fund manager before you invest with them. But the best ones make communication a priority. Nick Train of Finsbury Growth & Income, for example, has an extremely clear strategy: buy companies with durable consumer brands, run a concentrated portfolio, don't trade too often and ignore macroeconomics entirely. And, of course, there's Warren Buffett. Buffett runs an exceptionally complicated group of companies, sets up deals that only he could get done and uses a lot of financial engineering. Yet he makes a virtue and a selling point of clear and regular communication with investors. In each case, you know what you're getting, which is the minimum starting point for deciding whether or not you should invest.
Look for high conviction
While active fund managers have a poor record of beating the market as a group, several studies have shown that this isn't down to a lack of stock-picking ability. A study from about ten years ago by Randy Cohen, Christopher Polk and Bernhard Silli looked at fund managers' "best ideas". They found that the stocks that managers invested most heavily in did better than both the market and the rest of their portfolios. The researchers concluded that managers were over-diversifying the low-conviction ballast in their funds was holding them back. So you want to see conviction. By that I mean you want to invest with a manager who will spend time finding great ideas, then backing them to the hilt. The portfolio should be relatively small (as few as 20 stocks is enough to diversify away the majority of individual equity risk, although there's an argument for holding more as the companies in question get smaller).
Find asset nurturers, not gatherers
When you have a small amount of capital, you can invest in the tiny, neglected corners of the market that few others are paying attention to. If you have billions, then you need to invest in stocks that have the capacity to absorb big purchases without moving the share price. Those sorts of companies tend to be well researched, offering less opportunity for finding hidden gems. So it's easier to beat the market with a small amount of money than with a lot of it.
But this highlights the conflict between the art of investing and the business of being an investment manager. Behavioural investing expert Michael Mauboussin sums it up in his 2006 paper, "Long-Term Investing in a Short-Term World". "The investment profession is dedicated to delivering superior results for fund shareholders; practitioners tend to be long-term oriented, contrarian and patient. The investment business is about gathering assets and generating fees for the investment company as opposed to the fund holders." In other words, for fund managers it's ultimately more profitable to focus on getting bigger, than it is to focus on achieving excellent returns.
So you not only want to find a relatively small fund, but you also want to find one with explicit, well-explained limits on how large the fund will grow. That in turn suggests you should favour small, investor-focused, independent investment firms, rather than the big, profit-focused, fund-management brands.
Does the manager have "skin in the game"?
If you are going to put faith in a fund manager's ability to grow your hard-earned savings, then at the very least you should expect them to be putting a significant chunk of their own wealth at risk too. You don't want to be with a manager who merely sees themselves as a custodian of someone else's money, because at the end of the day, there's only so much that anyone can care about what happens to other people's money. In effect, you want someone who is managing their own money, with you tagging along for the ride.
This makes intuitive sense, but it's also backed up by evidence. In a recent paper "Skin or Skim? Inside Investment and Hedge Fund Performance" Arpit Gupta and Kunal Sachdeva looked at a database of US hedge funds, many of which were set up to manage "insider money" rather than money from external investors. They found that "funds with greater investment by insiders outperform funds with less skin in the game'" and they also outperform more consistently. This is in large part because the investors, as well as pursuing high-conviction strategies, make sure the fund doesn't grow too large.
Low costs and fair fees
Costs matter. Funds researcher Morningstar has demonstrated over and over again that one of the best predictors of future performance for active funds is cost cheaper funds do better and survive for longer than their more expensive counterparts. And you don't just want low fees you want a fee structure that will encourage the manager to do their best for you. Again, this is the sort of area where small managers usually have the edge. The managers are typically owner-founders of the business, so they care about keeping costs low in general; they are frequently motivated by a sense that the investment industry charges too much; and perhaps more importantly, a fairer cost structure gives them a competitive edge.
In an ideal world, a fund manager would take a reasonable salary and have a large proportion of their net worth invested in the fund alongside their clients. When clients do well, they do well and that's as far as their incentive goes. That may be too much to ask for from most managers. But scrutinise costs and pay particular attention to performance fees what benchmark does the fund have to beat? And is there a high-water mark (ie, the fee isn't charged until the fund hits a new high)? Remember the bigger the chunk of your savings you have to pay to a manager, the harder it is to outperform.
Be patient and diversify
As Howard Marks of Oaktree Capital points out, if a manager wants to "have a chance at the big money" then he or she must "assemble a portfolio that's different from those held by most other investors". If you behave conventionally, you'll get conventional results. The risk, however, is that "unconventional" behaviour cuts both ways. An unconventional approach to investing can see you trounce the market or badly underperform it. And even good contrarian managers will endure periods of the latter.
In a 2018 paper, Ben Inker of US fund manager GMO noted that in theory your success rate at picking fund managers could potentially be as low as 20% and you could still manage at least to match the market return over time. The difficulty is making choices and sticking with them. A 2011 study by Aaron Reynolds, cited by Inker, looked at 370 managers who had beaten their benchmarks over a ten-year period a rare and impressive feat. Yet during the ten-year period, nearly every manager lagged their benchmark by at least 5% in at least one year and one in four had underperformed by 15% or more. More pertinently because it would test the patience of any holder half had missed the benchmark by at least 3% a year for three years running and a quarter had made a relative loss of more than 5% a year. Remember, every one of these funds still outperformed over the ten-year period but during that time there were moments when most investors would be driven to sell.
So you have to be patient. This is why having a good grasp of a manager's strategy really matters as long as you feel comfortable that the problem boils down to a manager's style being out of fashion, rather than a genuine lack of ability, then you can afford to wait. And because you can't be sure that you'll pick the right managers at the right time, you want to diversify have a spread of funds and a range of strategies. That diversification will help you to ride out moments of volatility when one or other fund is having a bad time.
The Sceptical Investor (2019) is now available for a limited period of time at a 40% discount for MoneyWeek readers. Go to harriman-house.com/thescepticalinvestor and enter the code SCEPTICAL40 at the checkout.
