Maintaining a long-term view in volatile conditions, seeking out asymmetric returns and greater company interaction are how Scottish Mortgage Investment Trust’s James Anderson stays one step ahead of his peers. 
The fund management industry has had a difficult few years, with the rise of passive strategies continuing to make it harder for active managers to attract inflows.
“Fund management is frankly a very broken industry,” the Baillie Gifford manager said. “It’s more about people taking money out than actually either contributing to their shareholders’ wealth or, still less, doing the real job of fund management which is better known as capital allocation.
“And I think much of the debate about the problems is I’m afraid attributable to us and our refusal to invest properly and allocate capital properly.”
As lead manager, Anderson has been the driving force behind the £5.7bn trust’s consistent top performances.
Indeed, over one, three, five and 10-year periods, the trust is either first or second in the IT Global sector and has beaten the FTSE All World benchmark over all periods.
Performance of trust vs sector and benchmark over 10yrs
Source: FE Analytics
Anderson said: “It is important that we don’t just talk about the output in terms of individual companies and the way the portfolio is at the moment, but we say why we can be different.
“Fund managers are really odd people in lots of ways but one of the oddest parts of it is that basically our job is about understanding the competitive advantages of companies but fund managers don’t really – in most cases – have a clue about our own competitive advantages.
He added there are three areas he is focusing on in order to maintain the fund’s top performance.
One of which he has used for the last 15 years, the second of which has been an increasing focus over the last five years and the third of which he thinks is going to be critical in the next five years.
The first is being genuinely long term-focused, which he said is something that is easy to say but much harder to prove in practice – particularly to companies.
“Lots of fund managers will say they are long term but they are not if you look at the turnover of their portfolios,” Anderson said.
“You have to prove that you are genuinely long term and the people you prove that most to are not to shareholders but to companies who absolutely know the difference between those people that are committed to their company and those who are just tourists who have a piece of paper.”
He noted that examples of companies such as Amazon, which he has held in the portfolio for more than 10 years, demonstrate this.
“It is an incredibly strong advantage and it’s petrifying that it is becoming a stronger advantage,” he added.
“As the active fund management industry, particularly in America, comes under more and more pressure from passive investing the desire of those who run fund management firms to try and retain and gain funds by outperforming and boasting about three-month viewpoints becomes more intense.”
Performance of index over 10yrs
Source: FE Analytics
Indeed, passive investing has been increasingly popular in the US, with very few funds outperforming the S&P 500 over the last decade thanks in part to the strong performance of its largest constituents – technology companies.
“The second one, and again this is to do with the oddities of fund managers, is how we think about what the return structure is in markets and how we react to it,” Anderson said.
“There’s a whole set of behavioural scientists who will work out carefully that the average human being dislikes loss 2.5 times as much as they enjoy gains.
“That’s not true of fund managers. Fund managers at the very least dislike losses 10 times as much as they like gains.”
However, he said this unwillingness to stomach short-term losses can lead to managers missing some outstanding opportunities.
In the market, research going back to the 1920s suggests that the entire wealth creation of US stocks comes from just 4 per cent of the companies.
This means that those fund managers that sell out of top performers due to short-term factors are denying themselves long-term returns.
“The returns are very concentrated. So it’s not like the height distribution instead it is like the wealth distribution. With respect if Bill Gates walked into the room that changes things a bit,” he said. “What you have to capture is the Bill Gates outliers.”
“So what we have to do is get rid of that endless [focus on falling stocks] and give us the ability to buy the stocks with asymmetric return potential.
“That’s what we’ve been doing in the past, focusing on the long term and trying to overcome this fear of the downside for asymmetric returns.”
The third area he said he is able to outperform is by having better information than the market, something that comes with working closely with companies.
“There is great fallacy that the stock market incorporates all available information – it doesn’t,” Anderson said.
“People in fund management have a terrible problem coping with the huge expansion of information that is available so they’ve defaulted to doing really stupid and simplistic things.
“So we talk as though GDP is important but it has no correlation to stock market returns at all and never has done.”
Performance of US GDP over 10yrs
Source: FE Analytics
Indeed, while GDP in the US has steadily risen since the financial crisis of 2008, the S&P 500 took longer to recover before rocketing in the last few years.
“Secondly when talking about companies we talk about quarterly earnings. I don’t quite understand that,” Anderson added.
Again, he references Amazon.com – still the fund’s top holding after many years – which is a highly volatile stock.
“During the 11 years we have owned Amazon they constantly miss quarterly earnings and their share price regularly goes down 10 or 15 per cent on the back of that. It matters not one jot,” he noted.
“The value of a company is its future discounted cashflows, it is not what happened in the last 13 weeks.
“If you can get out of that sort of information you can huge amounts of value because you’re looking at an entirely different set of information.
He said the most important thing is to have a genuine relationship with companies, something that is built up over many years.
“They will actually then talk to you and what they see in 10 years’ time. They are willing to talk about problems that won’t be seen if you just want to get out and sell the shares.”