Outperformance of a fund is best explained by clear factors as opposed to cap-weighted geographic indices or individual managers, says Fahad Hassan, chief investment officer at Albemarle Street Partners.
An emphasis on value, quality and growth, as well as understanding of the market cycles are, according to Hassan, a more effective way of securing outperformance for individual investors.
“2020 was a year of tremendous turmoil and investors faced huge losses, particularly those in value-centric strategies,” he said.
Performance of UK shares based on style exposure
Source: Albemarle Street Partners/ Bloomberg and IA sector definitions
As the chart shows, value companies saw the sharpest declines but rebounded sharply in November, and this outperformance has continued throughout the first quarter of 2021.
But this value rally came after a decade-long bear market for the style, so how can investors stay ahead of the curve?
“There’s a lot of academic research that shows unless you’re investing with a certain goal in mind, then you are less likely to outperform over a sustained period of time,” said Hassan.
He added that outperformance relies on buying stocks that are cheap, momentum-driven and have a high degree of quality.
“Growth and quality companies are very similar,” Hassan added. “The only difference being that revenue is growing at a faster pace.”
Albemarle therefore focus on value, quality and growth when screening stocks, selecting those from the top quintile of each category.
“By doing that, we can create portfolios that are better diversified, as value has a negative correlation to quality, and mixing them together creates better outcomes over the long term.”
However, there are market cycles where an investor would be better off owning more of one type of stock.
“We’re in one of those periods right now,” he said. “It’s our view that we’re in a value market.”
The chief investment officer was clear that it is these underlying drivers that dictate fund performance, as opposed to the manager or process.
“A fund is essentially made up of the same market participants, with a different variation of 30-50 stocks, then called something clever and sold to your clients.”
He said that fund managers are committed to their style and “when these massive changes happen, they are almost unable to protect their performance”.
Although he added that underperformance isn’t an issue, as long as the factor itself is underperforming.
“If the manager is sticking to their knitting they will underperform. But if they’re not – then they’re changing their process,” Hassan said.
Hassan used the example of £8.9bn Lindsell Train Global Equity fund, where its quality-growth style is not in line with the current climate.
Performance of fund vs sector & benchmark over 1yr
Source: FE Analytics
“If [the manager] sticks to his style then the fund will underperform as this environment means he cannot outperform,” Hassan explained.
Style drift – or when funds start to invest in stocks that are different to their typical holdings – can affect any manager and occurs across all universes as managers fight to outperform their benchmarks.
“A value manager could drift into momentum stocks, or perhaps a bit of quality,” he said. “Rather than buying a bank or energy company, they could buy a lowly-valued consumer staple company.
“What they then run the risk of is when value does rally they will be away from their peer group.”
Hassan added that a manager who has drifted from their style will be left catching-up and could risk destroying performance relative to their peers.
A clear example of this style drift, added Hassan, was Neil Woodford and his LF Woodford Equity Income fund.
“People like to make fun of Woodford, but if he’d been in a value market, he wouldn’t have got into the trouble he did. But he was a value manager in a value bear market and he dug his heels in,” he said.
Attempting to outperform the benchmark, Woodford bought illiquid holdings that would, in theory, pay off over time.
“That would have been fine - if you understand that group of stocks,” Hassan continued.
“Managers spend time looking at what they’re good at – so when they do start drifting into other directions, then you do run the risk they’ll get it completely wrong.”
This also happens at geographic level, in particular UK-focused funds drifting into global stocks.
Hassan cited Ninety One UK Equity Income owning Microsoft in its portfolio.
“What gives them the expertise to go out and buy a US stock when they’re a UK fund?” he asked.
“That suggests a weakness in process around their core offering, because if there was a way to achieve that same performance within their universe then they’d do that.”
The ones that do outperform, he added, should not take it as a vindication of their stock-picking.
“Value will outperform now, but it’s not down to the manager,” he said. “It’s just the factor that’s helping them - no one’s cleverer than anyone else.
“They’re flavour of the day and currently it’s working, but when it turns, that arrogance might come back to bite them.
“We don’t believe in the repeatability of one month’s performance, but we do believe factor outperformance has been proven over business cycles and by using that as mechanism as oppose to finding the best managers in the world.”