How to spot a successful fund manager

I suggested last week that perhaps not all active fund managers are useless. The industry is guilty of many things greed, complacency, index hugging and overcharging for starters but that doesn't make it impossible for some managers also to be relatively good stockpickers.

I cited a report that suggested the average investor does not perform in line with the average fund, because the majority of investors' money is in a few very large funds. Create a weighted average, and the numbers look rather better. Some readers took this as a recommendation that investors should invest mainly in large funds. That's not what I meant you to take away at all.

A good many big funds are big because they have performed well in the past, rather than simply because they are big. We mustn't confuse cause with effect. This brings me back to the same analyst I quoted last week, Simon Evan-Cook of Premier.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

He has also looked at the best kinds of funds to be in, and the answer turns out to be"smaller, highly active funds that can repeat their success". And the worst? Smaller active funds that can't. You may assert that this isn't very helpful, but actually it might be.

I've pointed out before that the only way a fund manager can outperform all the time is to change his style to fit market fashion, and have perfect timing to boot. Mostly, they can't do that.

But one of the reasons why small funds often outperform in the few years after their inception is because they are launched with a management style that works in the market conditions of the time. Later, market conditions may change, and if the managementcan't adapt, they get found out.

So one of the key things to think about now might be what kind of stockpickers will excel at the moment. That brings us to growth, or the lack of it. When there isn't much growth around and markets also aren't particularly cheap as is mostly the case at the moment stocks tend to be volatile, but in aggregate, end up going nowhere much. But within the general flatlining, you can have pockets of outperformance.

Look at the 1970s, an era of volatility and poor economic growth. During this time, investors began to seek out and pay not just for income dividend yields were the basis of stock picking before then but for companies they knew could grow earnings as well. The focus on yield gave way to a focus on price/earnings (p/e) ratios.

As John Littlewood points out in The Stock Market (regular readers will know this is one of my favourite books), that gave rise to the great UK growth stocks of the time Beecham, Glaxo, Marks & Spencer and Thorn Electrical. In the US, it gave us the 'Nifty Fifty' IBM, General Electric et al. Investors piled into these shares and their p/e ratios climbed steeply.

It didn't last, of course. These stocks collapsed in the 1974/5 bear market, and as Alex Hammond Chambers, chairman of the Hansa Trust points out, the growth investing baton was passed to smaller companies. Their prices were bid up to the moon, and their p/e ratios likewise.

During the period as a whole, there was a huge difference between the ratings of companies perceived to be growing and those of companies perceived as ex-growth.

Come the 1980s, economic growth accelerated. Everybody's earnings rose, a great bull market was in full swing and investors started to look for value. As a result, p/e ratios converged and the spread between the highest- and lowest-rated stocks narrowed again.

Now we might be going the other way again. Low economic growth means that any stock perceived as offering consistent and quality earnings growth has been bid up for the last few years. There'll be volatility in it, but I suspect that it is a trend that has some way to run.

So what's the right fund to go for? I think you need to choose a smallish fund, run by someone patient and intelligent who appears to get this trend. He also needs to understand the point of low costs and to expend more energy thinking about trading stocks than actually doing it.

I have a few of these in mind myself, butadd your comments belowand we will make a list that will make us all rich. Maybe.

Finally, a quick word on wealth managers. A wealth manager has written in response to my article complaining about overcharging. This manager pointed to an elderly client of his who was very pleased with his management of her finances and who is happy to pay whatever asked for "security and peace of mind". He urges me to look less at cost and more at value.

I thought that was exactly what I did. "They never complain", is the classic defence of the overcharger. But what if they don't complain because they a) have no idea that it is possible to get the same smiley service for much less elsewhere, or b) because they have no idea how much they really are paying?

I looked up this particular manager's fees. The basic is quite high, if not actually awful, at 1% of assets under management. But there's a bite. If they make a trade for you valued at under £10,000, they'll charge you 1.65% dealing commission. That comes to £82 for a £5,000 trade that you could do yourself for a tenner in hundreds of other places. I think this one falls into category B.

This article was first published in the Financial Times.