The longer a fund manager’s track record, the more chances outperformance has been achieved by skill rather than luck, according to Hargreaves Lansdown’s Laith Khalaf.
Indeed, the key for recognising if a manager is adding value lies in analysing – and understanding – how performance has been achieved.
The senior analyst said performance data shows there is quite a wide dispersion between the returns you get depending on how good your fund manager is.
As such, the financial services firm has focused on trying to identify those active managers who have a good chance of outperforming in the future.
“Rather than looking at the fund performance, we actually look at the manager’s performance. To us, that is the important thing that is going to drive returns,” said Khalaf. “The longer you invest for, the bigger the differential, and it’s pretty significant over 20 years.
“A fourth quartile fund will deliver £20,000 on your initial £10,000 investment, whereas a top quartile fund will return £30,000 or £45,000, a huge differential.” 
He explained: “If you can tilt your portfolio towards funds which are more likely to be in the top quartile rather that a bottom quartile, that’s going to have a big effect on returns.”
Whilst most people tend to focus on three- or five-year performance, the senior analyst said Hargreaves Lansdown looks for outperformance over a relatively long period of seven years or more, to see how managers have done in the tough times as well as the good times.
“Over seven years you probably get a range of different market environments generally speaking, so you also get to see how managers have performed on down markets,” said Khalaf.
“If you have a 20-year track record for someone and there’s been a consistent outperformance, there is a good chance that there is something about them.
“Whereas, if you have a five-year track record you may have been lucky in terms of where your fund has been positioned.”
The senior analyst added: “If we are looking at a fund and the manager has changed three times in the last ten years, looking at performance during those ten years is not going to tell you much of what the position is going forward.
“We can look at that past performance and, the longer the time frame that we have, the more confident we can be about the ability of the guy who is driving the ship. The more confident that performance has been achieved by skill rather than luck.”
In order to do that, Khalaf said Hargreaves Lansdown uses various tools, with one of them being sticking together track records of the fund manager across different funds.
He said: “With Neil Woodford, for example, we have all the time at Invesco Perpetual and the time at Woodford Equity Income pieced together.”
Performance of manager vs peer group
Source: FE Analytics
As well as track records, Khalaf said the firm aim to understand how performance has been achieved by the fund manager, which they do with a six-factor analysis of the fund.
“First, we look at returns over the last 30 years form different segments of the UK stock market,” he said.
“The very top one is the highest yielding mid-cap shares, the next down is the highest yielding small-cap shares, then the highest yielding large-cap shares et cetera.
“From all the portfolio managers that we analyse we get monthly portfolio holdings so we have a full overview of their entire portfolio and how much they have invested in these various areas,” Khalaf pointed out.”
The six-factor analysis allows the team to build a picture of how their portfolio is positioned in terms of those various factors which are looking at size and yield.
What they see, Khalaf noted, is a huge differential in terms of the performance depending on the area of the market the fund invests in.
“There are some managers who will simply be positioned in one of these areas, as it’s their natural habitat,” said the analyst.
“Then, as far as we are concerned, if they are getting a headwind from that kind of performance that’s actually not value that they are adding, that is just part of their style.”
An example of manager who has added value over the long term is FE Alpha Manager Nick Train, who oversees the four FE Crown-rated LF Lindsell Train UK Equity.
“We basically say: ‘Nick Train, you’ve got 60 per cent invested in large cap low-yield stocks, what have those stocks in aggregate returned?’” said Khalaf.
“Essentially, we are building a sort of passive portfolio. Based on the performance of those passive units we can then build up a picture of how the fund should have performed based purely on its positioning, which gives us an expectation for what the returns should be.
“With Lindsell Train UK Equity we’ve plotted that and compared it to the FTSE All Share. Based on how this fund is positioned across these six different areas what we get is that the fund should have outperformed the FTSE All Share based on how it’s positioned.”
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
Once the bar for their expectations has been set, the team compare it to the actual fund return.
He explained: “What we can see is that over and above, just where he is positioned in terms of the size of the companies and also their yield, Train has actually delivered far in excess of that.”
Khalaf noted that the analysis can be replicated in many different ways, and will also look at the sector performance.
“Nick Train’s portfolio has a really concentrated sector list- with most managers you’ll see much more diversified – but he is mainly consumer business, consumer services and financials,” he said.
“He isn’t just performing because of where in the world he happens to invest, even within those regions he is picking good stocks and adding value.”
When looking at the performance of the fund in up and down markets, the analyst noted when markets have fallen, Nick Train’s fund has actually risen, meaning that the manager has protected in down times.
Since launch in 2006, Lindsell Train UK Equity has delivered a 285.89 per cent total return compared with a 108.01 per cent gain for the average fund in the IA UK All Companies sector and a 106.28 per cent return for the FTSE All Share index. It has an ongoing charges figure (OCF) of 0.70 per cent.