Wrong. It never ceases to amaze me just how many people seem to think this is the case, regardless of their experience in investing.
Assuming for the moment that one is comparing similar funds in a similar sector – and even that is a big "if" – it’s not always easy to make direct comparisons based on the oft-used matrices of past performance or well-known ratios such as Sharpe and Sortino, because ultimately it is very likely that unwittingly you are almost always going to be comparing apples with pears.
It is my belief that you should judge a fund and its manager by having a deep understanding of how the money is managed and what the medium to longer term outcome of the process is supposed to deliver, regardless of indices and benchmarks.
Suppose that hypothetically a manager states that the remit of the fund is to invest in UK smaller companies, to achieve a yield of at least 2.5 per cent and to produce an overall return over a three-year rolling period of 6 per cent per annum net of all costs and charges.
At the end of three years, if the FTSE has delivered an annual yield of 3.2 per cent and an overall return of 9.6 per cent, does this mean that the manager has 'underperformed' the market? Of course not.
FTSE represents the top-100 companies in the UK and is therefore large cap by definition. Because the index is weighted by capitalisation, it is massively skewed to the largest in the index.
According to the FTSE Group, in a study conducted at the end of last year, the top-10 companies alone represented 45 per cent of the index. In the prospectus, the manager states that the remit of the fund is to invest in smaller companies, so to be measured against a large cap index weighted to so few companies is ludicrous.
Therefore, just because the FTSE has a yield of 3.2 per cent and an annualised return of 9.6 per cent over three years does not mean the fund has failed. All of us – that is, the investing public, advisers, journalists and the fund management industry – are obsessed with performance when the focus should be on whether the fund manager set out to do what he said he was going to do, in the way he stipulated he would achieve it.
So much for the theory. Let’s look at a real case study.
I like a fund called PFS Downing Active Management, which is managed by Judith Mackenzie. She runs a micro cap focused portfolio, meaning that she invests predominantly in very small companies even by the standards of the smaller companies universe.
It has been in existence for a number of years, albeit under the management of a number of different fund groups, and as a consequence does not currently have a conventional longer-term track record. The fund was re-launched two years ago following a period of very difficult re-structuring.
I was introduced to the manager in the autumn of 2012 and was immediately impressed by her conviction in, and clarity of, the investment process. The manager has a quite different mind-set, which is: "If I were a private equity investor, would I invest in this company?"
She looks for companies with strong and honest management teams and a good product or service and will often take a seat on the board. In addition, the manager might replace bank loans with a debt facility, the rationale being that there is security over the asset and it also provides enhanced investor rights such as control over board appointments, raising equity, raising debt and so on.
Although the manager does not issue debt to companies in the expectation of exercising the rights, it does offer an element of protection if the management team were to ever change, or in case of disagreements.
In February 2013 I explained in an interview with FE Trustnet why I was investing in this particular fund, and the reception was far from rosy. All of them thought I was a loony for recommending the fund given that it had underperformed, and god forbid, sat in the fourth quartile of its sector over certain periods.
Of course, everyone is entitled to their opinion, and sometimes underperforming funds do indeed keep underperforming. The problem here, however, is that these comments seemed to have been made without looking under the bonnet of the fund in question and finding out why the manager had underperformed.
Performance of fund vs sector and index since launch
Source: FE Analytics
Since launch, the fund has marginally beaten the FTSE AIM index, but is indeed one of the worst-performing funds in its IMA UK Smaller Companies sector; however, this must not be taken at face value.
First of all, Mackenzie and co-manager William Barker didn’t take over the fund until February 2011 and since then, its record is much stronger. Not only has the fund comfortably beaten the AIM index – to which it is most closely correlated to – but it is on course to achieve its target return of 15 per cent per annum, which is implicitly referred to in its objective.
Performance of fund vs sector and index since Feb 2011
Source: FE Analytics
Just as importantly, there are certain issues that investors wouldn’t know about without carrying out proper due diligence, as the manager herself explains: "We spent six months sorting out major problems not of our making and removed an outrageous performance fee – with no hurdle – which saw investors lose over 8 per cent in 2010 [but still pay out a fee]."
"We personally bore that corporate restructuring cost and since we took it on we have outperformed the AIM index and are on target for achieving our 15 per cent per annum targets."
"If investors don’t understand and don’t do their own proper due diligence, we don’t want them as investors – and it’s why this fund will never be larger that £30m. Unlike other fund houses, I will not prostitute the philosophy and style of the fund simply to increase the annual management charge."
I, for one, have to agree. Whether you’re looking at a fund that’s at the top of its sector or languishing at the bottom, numbers shouldn’t just be taken at face value – all performance needs to be understood and put into the context of what the manager is trying to achieve.
In a previous article on FE Trustnet, we looked at why investors should often be wary of the best-performing funds.