As seen in this month’s Master Investor Magazine
There are many different ways that active fund managers approach the challenge of beating the market. Some are mainly price driven and will buy a stock even if they don’t rate the business as long as they think they can make money out of it. Others take a much longer term view and will only invest in quality companies that can deliver superior returns for years to come.
Unfortunately it is not always immediately apparent which category a fund falls into and you normally have to do a lot of digging around to find out. The best indicator is the portfolio turnover rate, which measures how often a fund manager buys and sells assets. It is usually calculated by looking at the total value of shares bought or sold (using the lower figure) over the course of the year and then dividing by the aggregate net asset value.
You can find the portfolio turnover rate in the fund’s annual report. A figure of 200% would imply that the manager has replaced all the assets in the fund twice during the year. It could also mean that they have traded a fifth of the portfolio ten times.
A manager that invests in quality companies and then holds onto them for long periods of time would normally have a much lower level of portfolio turnover. This sort of buy and hold strategy would typically give rise a turnover rate of between 20% and 30%, whereas anything above 100% would indicate more active buying and selling.
Unfortunately there are a lot of problems with the portfolio turnover figure, with the main one being that it is distorted by client sales and redemptions. Whenever an investor puts money in or takes money out of an open-ended fund, the manager has to invest or disinvest the cash. This forces him to buy or sell assets, which is not something that his closed-ended counterparts have to contend with.
The Investment Association has been looking at this whole area and has proposed a diagram that shows the fund’s portfolio turnover rate and how it compares to its peer group along with the relative cost of the transactions. This would make it easier to know what sort of fund you are investing in, but we will have to wait and see whether it is adopted.
Cost-benefit analysis
The reason they have been scrutinising this issue is because of the lack of transparency of the charges borne by investors. An actively managed fund that trades on a frequent basis would incur much higher transaction costs than one that invests in quality companies and then holds onto them. There may also be more tax on the capital gains, which would be another additional expense.
In the UK All Companies sector, the average portfolio turnover rate across all the funds works out at around 89%. Each time the manager makes a UK share purchase he will have to pay half a percent in stamp duty, there would also be commission payable to the broker and the bid-offer spread, which all adds to the cost of the transaction.
Martin Bamford, MD of Informed Choice, Chartered Financial Planners, says that portfolio turnover seems to have an impact on costs and also on taxation within the fund.
“Funds with higher portfolio turnover do seem to perform worse than those with lower portfolio turnover, as a result of the drag these trading charges have on performance. The Investment Association are still working out a clear way to disclose product and transaction charges, so it can be tricky for investors to see how much they are paying, and portfolio turnover figures are sometimes hard to identify.”
Higher portfolio turnover is not necessarily a bad thing, it is just that the manager would need to make sure that the additional trades more than justify the higher costs so that the overall performance is not adversely affected.
‘Buy & hold’ open-ended funds
One fund that focuses on quality is CF Woodford Equity Income. This was launched in June 2014 and has already amassed assets under management of £5.73bn. The manager, Neil Woodford, uses the same successful strategy that he employed while at Invesco Perpetual. He describes it as investing in good quality companies that can deliver sustainable dividend growth with the focus on the long-term.
CF Woodford Equity Income has a concentrated portfolio with the top 10 holdings accounting for 46% of the fund. These include: AstraZeneca, Imperial Tobacco, GlaxoSmithKline, British American Tobacco and BT. The fund is currently yielding 4% and is defensively positioned given Woodford’s cautious outlook.
Another high profile advocate of this approach is Terry Smith. Smith is a vocal critic of the asset management industry and launched his own fund, Fundsmith Equity, to challenge the status quo. It invests in global equities and takes a long-term approach.
Smith targets high quality businesses that can sustain a healthy return on operating capital employed, whose advantages are difficult to replicate and that do not require significant leverage to generate returns. The companies also have to be resilient to change and be trading on an attractive valuation.
Fundsmith Equity has a concentrated portfolio of 20 to 30 stocks. The top 10 holdings include the likes of Microsoft, Imperial Tobacco, Dr Pepper Snapple, Unilever and Domino’s Pizza. Since it was launched in November 2010 the fund has generated annualised returns of 17.9% compared to the 12% produced by the MSCI World benchmark.
“Investing in quality companies can play an important part in a portfolio, delivering what should be more stable and predictable long-term returns,” says Bamford.
He highlights the Morgan Stanley Global Quality fund as one that follows this approach. Its objective is to generate a long-term return by investing in quality global companies in the world’s developed countries. The fund is relatively new having been launched in August 2013 and has a portfolio turnover rate of 31%.
“Examples of companies in the portfolio include: Nestle, British American Tobacco, Unilever, Google and Microsoft. Over the past year, the fund has delivered a return of 4.36% compared to a sector average of 11.55%, although we prefer not to judge the performance of a fund until its third or preferably fifth anniversary,” explains Bamford.
Another fund with a similar theme is Sanlam Private Wealth Global High Quality. It has a small portfolio of 26 high-quality stocks and aims to outperform the MSCI World Index over the medium to long-term. The largest holdings include: Rolls-Royce, MasterCard, Coca-Cola and Philip Morris International. Over the last year the fund has returned 17.6%, compared to the benchmark return of 19.2%.
Quality closed-ended funds
Closed-ended funds do not have to deal with client sales and redemptions as investors simply buy or sell the shares on the stock exchange whenever they want to increase or reduce their exposure. This makes for a more stable portfolio and cuts down the number of transactions that the manager has to make for administrative purposes.
One of the most successful managers in this area of the market is Nick Train, who runs the Finsbury Growth & Income and Lindsell Train investment trusts. Both have similar concentrated portfolios and share many of the largest holdings.
Train looks for quality companies that he thinks will be around in 50 years’ time and on average he retains them for a remarkable 18 years. He recently said that ‘other investors persistently underestimate quality, resulting in unduly low market valuations for the very best companies.’
This suggests that there is an enduring market inefficiency to exploit, which leaves him with the challenge of identifying these companies and working out their intrinsic value so he knows whether they are undervalued or not. The way he does this is to look for sustainable business models that can generate extraordinary returns for long periods of time and then assess the present value of the future cash flows.
His largest holdings in Finsbury Growth & Income include the likes of Unilever, Diageo, Reed Elsevier, Pearson and Heineken. Over the last 5 years the fund’s share price is up 154% compared to the 65% increase in the FTSE All-Share, yet Train remains extremely bullish. This is because he thinks that factors such as technology, fracking, digital and biotech will push down inflation – thereby raising consumer disposable real income – while also increasing the opportunities for companies to grow.
Simon Elliot, an investment trust analyst at Winterflood, says that Train is an extreme example of a buy and hold manager as he looks for companies that will deliver growth over a long period of time.
“It is an increasing theme as more and more of the managers that we speak to talk about having an ownership attitude towards the stocks in their portfolios. Most tend to have a 4 or 5 year holding period in mind, which would imply a portfolio turnover rate of around 20% to 25%.”
He says that Baillie Gifford applies this long-term approach to all of their closed-ended funds and also highlights Templeton Emerging Markets. Its manager, Mark Mobius, has a real buy and hold mentality as witnessed by the 15.5% portfolio turnover rate in the last published accounts for the year ended 31st March 2014.