Active Fund Selection
Science or Art? Harry Garrett, Investment Director
Is active fund selection a science or an art? Our Investment Director Harry Garrett takes a deep dive look into ...
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Parmenion Investment Management (PIM) offer passive and active versions of selected solutions, so advisers and clients can make recommendations based on their clients’ personal needs and approach.
It’s true that many active managers don’t outperform their benchmarks. However, as a provider of active investment solutions, we have a proven, disciplined process to help identify high-quality managers who consistently produce alpha over the long term.
Here you can see some of the classic metrics considered when trying to identify ‘good’ funds. These key factors are highly subjective. None truly prove a manager’s skill, as there are many variables that can impact fund performance outside of the fund manager themselves. Every decision can lead to a vastly different outcome.
To illustrate this, let’s look at all the funds within the IA UK All Companies sector that have a track record of seven years or longer. In total, this is 215 funds.
We’ve taken each 12-month period on a monthly rolling basis since early 2010 (146 unique 12-month periods) and percentile ranked each individual period. 1st percentile is the best performer and 100th is the worst performer in the sector.
This chart shows each fund across the horizontal axis, identified as a number. The light red is the fund’s best one year rank. The dark red line reflects the fund’s worst one year rank, versus the same universe of funds.
Almost every fund has been in the top 10% AND in the bottom 10% at some point.
Let’s hone in on one random fund from those 215. Here you can see the fund’s journey through the percentile ranks over the 146 data points. This demonstrates the difficulty in identifying a good manager using performance versus peers. Based on the final 12-month period in the data set, the fund is 93rd percentile, one of the worst funds within the IA UK All Companies sector.
If we roll back to the one-year period ending late 2020, the fund was 1st percentile - the absolute best fund versus its peers. And that rollercoaster is evident throughout. So, is it a good fund or a bad fund?
Let’s look at the consistency of outperformance versus the FTSE All Share benchmark, using the same dataset.
208 funds were able to outperform the benchmark between 10 and 20% of those 146 rolling one-year periods.
As you move through the consistency bands, the number of funds able to outperform falls. The extent of that fall increases after 40% consistency, with only half of the active universe able to outperform the benchmark for more than half of those one-year rolling periods.
Ultimately, the conclusion is that it’s completely random how good a fund looks, depending on when you’re looking at it.
Yes, 12 months is a short time, but the market obsesses over these short-term periods, in some instances looking at an even shorter time frame.
Each manager goes through the percentile ranks versus their peers not because they flip between being a great manager and a terrible manager but because the market is dynamic and the investment environment is constantly evolving.
The market moves in cycles, so different points of the cycle will suit different managers’ investment processes. It’s much more complex than just “growth vs value”.
How do we achieve consistency in our asset class returns when the backdrop is one of randomness?
The answer is simple – diversification.
We aim to identify high-quality managers that complement one another through the market cycle and who, when combined, can together produce long-term alpha versus the benchmark.
The benefit of this blending process is that it removes many of the behavioural pitfalls of single-fund investing. It means we can ride out those periods of underperformance, which pretty much every fund manager will go through, no matter how good they think they are.
Using our Asia Pacific ex-Japan asset class as an example, this chart demonstrates the benefits fund blending can bring.
It’s clear that both funds have had periods of strong returns and poor returns, but the key point is that they’ve gone through these periods at different times in the market cycle.
The next chart shows the same thing, but rather than percentile rank it shows rolling relative one-year returns versus the index.
The conclusion is the same. Veritas has had periods of strong returns versus its index, as has Schroder.
By blending the two managers, the return profile of the combined asset class is more consistent with lower volatility, enhancing risk-adjusted returns.
It also avoids the major behavioural pitfall of questioning whether something should be sold because it has been through a poor period of returns. Blending means the other fund is there to pick up the short-term slack at the overall asset class level.
Accepting that there is no perfect fund and assuming that all funds will go through these periods will help prevent poor decision making. That’s not to say a fund should never be sold, but poor performance alone should not be the reason.
By being disciplined in this way, investors are often rewarded.
While asset allocation is the bedrock of portfolio returns, it’s active management that can really enhance potential returns."
Let's look at the same rolling percentile ranks using our blended Asia ex-Japan asset class and index, over rolling three-year periods.
The individual funds we invest in have gone through short-term periods of underperformance, but by sticking with them, the longer-term outcome is consistently strong returns versus peers and the index. Below, you can see the relative % outperformance of the PIM asset class over the last 24 rolling three-year periods vs index. Like the peer group ranking, this demonstrates consistent, material three-year outperformance of the Asia Pacific ex-Japan index.
Of course, some readers might be thinking:
It’s a fair question.
We have the processes, discipline, and capability within our investment team to identify high-quality managers that can produce alpha over the long term. There is no silver bullet to fund selection and there are a lot of funds out there to choose from.
