An overreliance on one particular investment style is the real reason so many fund managers fail to beat their benchmark in the US, according to Old Mutual Global Investors’ Ian Heslop.
The underperformance of active fund managers in North America is nothing new for investors with the average active fund in the IA North American sector underperforming the S&P 500 over the last three years.
Indeed, over the last 10 years, the sector average has beaten the S&P 500 in just three calendar years – 2007, 2009 and 2013 – with the index outperforming in all other years and on course to do so again so far this year.
Performance of sector vs benchmark over 10 calendar years
Source: FE Analytics
When Heslop (pictured) first thought of running a North American fund his immediate priority was to address why active managers have struggled so mightily.
“At the start I took a step back and said why should that be the case?” the manager of the four crown-rated Old Mutual North American Equity fund said. 
“There is a number of reasons that people give. The first one, and you can’t really get away from this in my view, is that many funds don’t take enough risk,” he added.
“If you are a pseudo or closet tracker you are not taking enough active risk to generate outperformance relative to an index and then you layer on active charges you are going to underperform the index.
“There is nothing you can do about that, it is just how your returns occur.”
The second and most common argument is that the US is more efficient than many other developed markets, with companies more transparent and regulation more stringent.
“There is some argument to that,” Heslop said. “You could in theory take an idea that there is huge amounts of money flowing in the US markets and the mispricing can be very short term.”
However, one example that this may not be the case is the financial crisis of 2008, when markets crashed on the back of a housing bubble that some had been predicting for years beforehand.
“2008 was a very big deal for fund managers and was very unpleasant. Markets came down 30-40 per cent based upon information we already knew – that doesn’t sound like a very efficient market to me,” he added.
Therefore while the market can be efficient at times, the manager said this is not the case at all times and is therefore a very broad brush to use for defining such widespread underperformance.
The third argument Heslop noted many commentators use is that US fund managers are “just inherently crap – they’re not very good at what they do”.
However, the manager said he does not believe that this is the case due to the cutthroat nature of the asset management business.
“I’ve met stupid fund managers – we all have – but this is a very Darwinian job that we do,” he argued.
“You are allowed to run someone else’s money until they decide you are not very good at it and they will take it away and give it to somebody else.
“So the idea that stupid people sit in fund houses running other people’s money forever is impossible to believe.”
Heslop has a different reason therefore why a vast amount of fund managers in the US have struggled to outperform over the long term.
Percentage of funds outperforming the index over rolling 3yr periods by calendar year
Source: BMO Global Asset Management
Indeed, as the above shows, over three-year rolling periods by calendar year North American funds have outperformed the index just 38 per cent of the time, significantly below other markets.
“Three-quarters of US funds running against a US benchmark in the UK last year underperformed, meaning just 26 per cent beat their benchmark last year. This is consistent through time,” Heslop added.
“What I think it is, is a lot of active funds are too style concentrated to consistently outperform an index.
“If you have loads of cheap stocks or growth stocks or quality stocks in your portfolio, you will work sometimes and you will not work at other times because styles move in and out of favour.”
He said that indices such as the S&P 500 are more diverse than many funds, with all components of the market incorporated rather than just certain styles.
“If your index, like the S&P 500, is diversified across a number of different styles, the absolute return to that index is somewhat more stable than a fund that has just value stocks in it, for example,” the manager noted.
While this is not to say that these style-biased funds cannot outperform, it means that when such styles are out of favour they will naturally underperform.
“From 2012 to 2015 and from 2007 to 2009 cheap stocks just kept getting cheaper. For example if Cisco is cheap at $15 you buy it, if it is at $10 you are buying a hell of a lot more. If it’s at $5 you are buying even more. This is kind of like a vortex that you get sucked into,” he explained.
“You are buying stocks that, though you agree that the underlying fundamentals are what you want to capture in the portfolio, the market is not interested. So having a style concentration is the Achilles heel of fund management.”
This has been particularly apparent in recent years, with styles rotating in-and-out of favour rapidly in the US.
Last year the value style appeared to be back in favour but this year there has been a reversion back to quality stocks, he explained.
“One minute value works, then growth works, then quality works. It has been massively rotational over the last 18 months and that’s the issue many people have been dealing with,” the manager added.
“If you are very concentrated at a style level in an environment where styles are basically massively rotational it will be hugely impactful on alpha generation.”
The other area managers can come unstuck is attempting to pick macroeconomic events, which have come to the fore in recent months globally with the Brexit vote and the US election victory of Donald Trump.
“We’ve gone through a period where trying to forecast macro and build portfolios around that has been a mug’s game in my opinion,” he said.
“With macro you are effectively forecasting two separate things – some kind of event be it interest rates or GDP growth or oil prices etc. – and then you have to try and forecast the impact of that event on the asset class you are investing in.
“It is really difficult to get both of those things right and you had the classic examples last year of Brexit and Trump. If you got Brexit right you would have got the market reaction right for about seven days. If you got Trump right, which was a slightly more difficult forecast to make, you got the market right for about seven hours.”
Due to these factors, the process behind Old Mutual North American Equity is designed to be diversified across styles and does not have a large concentration across any individual style or sector currently.
“The market is not in a position right now where you can take big concentrated positions in your portfolios because it is just not apparent to me that you are getting a signal from the market that those positions are going to be rewarded on a risk-adjusted basis,” the manager said.
Heslop runs the £2.1bn Old Mutual North American Equity fund alongside Amadeo Alentorn and Mike Servent.
It has 166 holdings with a 26.2 per cent weighting to technology, 18.5 per cent in healthcare and 14.6 per cent in financials.
The fund has outperformed the IA North America sector and MSCI North America benchmark over the last one, three, five and 10-year timeframes.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
The fund, which has a yield of 0.38 and a clean ongoing charges figure of 0.95 has beaten the index in six of the last 10 calendar years and in each of the last four years consecutively.