Pretending otherwise is a comfortable delusion that makes us feel intelligent, special and in on a secret set of knowledge that those outside the industry don’t share.
Predicting what will happen to the stock market is like predicting what will happen to the weather: foolish and ultimately self-defeating.
Like the Met Office, you can keep up your credibility for only so long before people realise that you can get a better idea of what is going to happen by looking out the window to the far edge of the sky.
In fact, some investors swear by just such that method, which goes by the name "momentum trading" in this industry.
Momentum trading consists of buying what seems to be going up and holding it until it starts to go down – the investing equivalent of putting on shorts if it looks nice in the morning even if the forecast is for rain. It tends to work quite well, as long as you’ve got a change of clothes on hand.
Reading economic commentators in the financial press is a lot like reading lots of different weather forecasts from different providers. They’re all using roughly the same instruments and looking for roughly the same indicators, prioritising some over others.
And like weather forecasters, they are all hamstrung by the same flaw in the process: they don’t really understand the system they are describing.
The economy, like the weather, is highly complex and, at least at the moment, beyond our comprehension. There’s a strong argument that it always will be beyond our comprehension, resting as it does on human behaviour, but that’s for another day.
This isn’t to say that it is impossible to produce superior analysis, of course. Some people get it right on a stock or a fund or a market. But no-one always gets it right, because there’s always something that isn’t expected, isn’t included in the calculations, or is unforeseen.
From the point of view of the investor this shouldn’t matter, as long as they aren’t betting all their savings on any one strategy.
Different strategies and styles work in different markets and just because a fund underperforms in certain circumstances, this isn’t a reason to ditch it.
Consider Liontrust Special Situations, a fund with an excellent track record that has won it many plaudits, including five FE Crowns. However, over the past year the fund has made just 19.9 per cent while the FTSE All Share has made just 18.72 per cent.
Performance of fund vs index over 1yr
Source: FE Analytics
This is quite a fall from grace for a fund that was in the top quartile for the preceding five calendar years.
The active management cynics would say that this shows that funds eventually revert to the mean and you would have been better off in a cheap tracker over this most recent period.
However, that’s a simplistic way of looking at things. It’s worth asking why the fund has been doing relatively poorly this year.
The last year it underperformed [finishing in the third quartile] was in 2007, which was also a year of a general rising market, and in a buoyant environment prior to the financial crisis that created a whole new state of play.
It may be that the fund is better suited to an environment where stockpicking is more important and cyclical areas come under pressure.
Or it may be that there is something about the market that we have just been through that was uniquely suited to this style – perhaps the relative difficulty of getting funding for a business played into the hands of the funds managed by FE Alpha Managers Anthony Cross and Julian Fosh? In this case, we might perhaps expect the underperformance to continue.
Or perhaps the fund’s weighting to certain sectors where IP is more important has paid off in a boom time for those sectors? The only conclusive answer to this question will come with time.
For this reason it would be foolish to sell out of this fund. It makes much more sense to look for those that complement its style and are likely to do better when it performs relatively poorly.
One such fund could be Schroder Recovery, managed by Nick Kirrage and Kevin Murphy. This fund has done particularly well this year, having also outperformed the Liontrust portfolio in the recovery year of 2009.
By contrast in 2011, when the market lost money, the fund came under much more pressure than the Liontrust portfolio, which excels in falling markets and was the leading portfolio in the sector in that year.
Performance of funds vs index and composite over 5yrs
Source: FE Analytics
In the graph above I have included a portfolio weighted 50/50 between Liontrust Special Situations and Schroder Recovery. It clearly shows that there have been periods when the portfolio has outperformed the Liontrust fund and when it has underperformed and that we are currently seeing the gap close.
Whether that trend will continue or not I don’t know, but I do know that holding both funds gives me a better result if it doesn’t and a better result than holding Schroder Recovery if that underperforms.
Certainly, looking at the past few years, a tracker fund would have done much worse for us than either of the two active funds, and a mixture of different strategies with a proven record of doing better in certain circumstances gives us the best chance of outperforming the index again in the future without betting the lot on a single approach or manager.
Of course, all this is premised on the behaviour of the managers remaining the same, and this is key. You can hedge away the risk of different strategies not working, but only if the managers stick to their style.
If Cross and Fosh were to suddenly start buying companies that they thought would do well in the next three months, no matter the sector, then that would be a reason to re-evaluate holding the fund.
For this reason I’d rather stick with Sebastian Lyon’s Personal Assets Trust, which has come in for a lot of stick of late after its recent underperformance, than switch into a fund that was chasing the rising market.
Lyon has been perfectly consistent in how he has managed his fund, and he aims to protect capital, take into account tail risks, and prepare for inflation. As long as you don't think there is no chance at all of one of those events coming to pass, then it makes sense to hold this fund.
It did fantastically well in 2011 and was the top-performer in the IT Global Growth sector. However, it was in the fourth quartile in 2009, 2010 and 2012.
A graph of relative performance against the FTSE clearly shows this pattern of doing well when equities tank and lagging when they rise.
Relative performance of trust vs benchmark over 3yrs
Source: FE Analytics
It might make sense to increase the weighting in your portfolio to the strategies that are currently successful – this would amount to a sort of momentum trading – but cutting out the less successful ones altogether will leave you dangerously exposed when the market turns.
Because the market will turn, and no-one knows when and for how long. All we can say with certainty is that the funds that are at the top of the table now will not be so in the future.