High conviction stockpickers willing to take “punchy positions” and hold them tend to outperform by the highest margin, according to Kepler Trust Intelligence’s William Sobczak.
The investment trust analyst said while passive funds will naturally underperform benchmarks after fees few active managers have demonstrated the ability to outperform. Those that have tend to run more concentrated portfolios.
Sobczak said: "The overwhelming evidence is that fund managers who are willing to back their convictions with punchy bets are the ones that tend to outperform by the highest margin.”
The Kepler analyst noted Antti Petajisto’s academic research on active share and tracking error suggest that the most active managers tended to outperform their benchmarks even after fees.
Petajisto together with Martjin Cremers in 2006 found that most active stock pickers were able to beat their benchmark on average by about 1.26 per cent a year after fees.
However, the analyst said studies suggested that the most bullish ideas are the ones that consistently deliver greatest returns although highly concentrated portfolio are not “optimal” for most managers and tend to add lower conviction stocks.
The analyst noted that Cremers later found that fund managers with a more patient perspective and holding durations of more than two years outperformed by over 2 per cent per year.
Sobczak added: “In comparison, the funds who traded frequently generally underperformed, regardless of having a high active share.
“Cremers found that the closet indexers and low active share funds on average underperform even with patient strategies.”
As such, Sobczak said investment trusts may hold an advantage over other funds.
He explained: “There are well rehearsed arguments that the capital structure gives managers the ability to take a longer-term view on the investment opportunities available.
“Alongside this, being able to build up a revenue reserve allows the manager to consistently deliver a smooth income, not make short term reactive decisions, and plan for the future depending on the long-term outlook.”
He added: “Finally, and arguably most importantly, because investment trusts have independent boards, the manager is answering to people with investors’ long-term goals in mind rather than the short-term swings in sentiment that open-ended fund managers are open to.”
The Kepler Trust Intelligence analyst said that its own analysis had shown that the average number of holdings for an equity trust has decreased by more than 10 per cent over the past five years from 91 in 2013 to 82.
However, he noted that while the data and anecdotal evidence had revealed portfolios were becoming more concentrated, not all sectors had seen such a contraction.
Turnover has also declined by around 20 per cent over the past four years, said Sobczak noting a shift towards more patient strategies. However, this too, varies from sector to sector.
“The lowest portfolio turnover over the past year was the Japanese sector at 16.37 per cent whilst the largest turnover came from the global equity income sector – with an average turnover of over 40 per cent,” he noted.
As such, the analyst said it had noted a number of trusts that appear to have put the academic theories into practice.
“In large part their results suggest the theory is sound – concentrated portfolios have outperformed over the long term,” he said.
The best example of a manager that has both low turnover, highly concentrated portfolio and strong outperformance is FE Alpha Manager Nick Train, according to the analyst.
“Over the past ten years Finsbury Growth & Income has delivered returns of around 297.4 per cent in comparison to the 96.6 per cent returns from the FTSE All Share,” he noted.
Performance of trust under Nick Train
Source: FE Analytics
“Supplementing his portfolio strategy, Nick believes that the Lindsell Train business model encourages patient investing,” said Sobczak.
“He points out that a small, flat team, in particular, contributes to performance by ensuring that employees aren’t compelled to continually offer new ideas in a hope to gain greater recognition.”
The analyst said another stand-out trust from the AIC Global sector is the £432.7m, five FE Crown-rated Independent Investment Trust (IIT).
The trusts focus on providing strong returns over extended periods gives the managers “an unusually high degree of freedom”, according to Sobczak.
“With a portfolio of 23 stocks relative to the peer group average of 80, IIT has it has performed handsomely over both the short and long term,” he said.
“Over one, three and five years the trust has doubled the returns of the MSCI World, delivering NAV [net asset value] returns of 23.9 per cent, 98.7 per cent and 162.4 per cent respectively.”
Performance of trust vs sector over three years
Source: FE Analytics
However, there are several trusts that don’t quite conform to the rules.
Indeed, there are some trusts that stand out for their high conviction approach with heavily concentrated top-10 holdings or more concentrated relative to their sector peers.
An example is FE Alpha Manager Alexander Darwall’s Jupiter European Opportunities trust which has 42 holdings compared with the sector average of 70, with the top-10 representing 70 per cent of NAV.
“Alexander Darwall has an enviable long-term track record which provides good evidence that a concentrated approach can help to offer returns greater than the benchmark and peers,” said Sobczak.
Another example is the popular Scottish Mortgage investment trust which while having 95 holdings, has 53.6 per cent of its NAV represented by the top-10.
“Run by James Anderson and Tom Slater, the portfolio revolves around investing in innovative companies that the managers believe can revolutionise established industries,” he added.