The financial media, retail investors, and scarily, most advisers do not know how to compare apples with apples.
The common mistake I see across the financial media, retail investors, and scarily, most financial advisers are not comparing ‘apples with apples’ when it comes to selecting fund managers.
I’ll try my best to give the Livewire community a framework for comparing managers and some basic data points, beyond just trailing returns, on which you can anchor your decision-making.
This is a ‘media-friendly’ version of part of what the Seneca Investment Committee works through each month when choosing managers and implementing for our clients across our range of separately managed accounts (SMA’s).
It’s certainly not the only way to skin this cat, but it works for us and it’s a whole lot better than what I see most advisers and self-directed investors do (which is just sort by trailing returns or invest with whatever manager they liked the sound of in the latest piece of media spin.)
Remember, I am limiting this conversation to a single asset class, Australian Equities. The way we think about Global Equities, Fixed Income, and Absolute Return/Alternative Strategies is a bit different and if you want me to cover that in a future article, drop a comment or contact us.
Step 1: Categorise
We categorise Australian fund managers into peer groups of similar strategies. The table below breaks down the managers in the asset class by the number of companies they hold in the portfolio (concentration), the strategy they employ/or mandate limitations, and the benchmark they choose.
| Peer Group | Concentration | Strategy | Benchmark |
| Core | > 20 companies | Long only | S&P/ASX 200 (INDEXASX: XJO) or S&P/ASX 300 (INDEXASX: XKO) |
| High conviction | < 20 companies | Long only | S&P/ASX 200 (INDEXASX: XJO) or S&P/ASX 300 (INDEXASX: XKO) |
| Small Cap | > 20 companies | Long only | S&P/ASX Small Ordinaries or Emerging Companies |
| Long/Short | N/A | Can utilise short selling, hedging | Absolute Return (CPI + or RBA Cash Rate +) |
| Geared | N/A | Can utilise gearing | Gearing-adjusted S&P/ASX 200 (INDEXASX: XJO) or S&P/ASX 300 (INDEXASX: XKO) |
Not every product assessed will fit perfectly into our framework, and that’s okay. The idea is to create a level playing field for each product – our goal at this point is to avoid confusion, not make decisions.
Step 2: Allocating funds
For our clients, core funds are going to make up 50-80% of the allocation to Australian equities at any given time. Diversified exposure to the equity market (beta), over long-time horizons is a proven way to generate high (relative to other asset classes), positive, inflation-adjusted returns, provided investors don’t panic and sell when the inevitable period of volatility arises.
We compare active and passive alternatives on an after-fee basis, without dogmatic bias or preference. In core Australian Equities, there is more than sufficient evidence in favour of paying an active manager over the long run (particularly when our in-house product is free for those clients paying for ongoing advice.)
The allocation to non-core strategies will depend on the Investment Committee’s assessment of the potential for, incremental risk-adjusted return. It would be unusual for us to not have at least some exposure to an active Australian small-cap manager, however, we’ve yet to ever include a geared strategy in our Separately Managed Account.
We conduct ongoing analysis of the markets to answer questions like:
- Do small caps look undervalued relative to large caps?
- Is the Australian market likely to move sideways and favour a particular long/short manager’s style? or,
- Are we entering a bull market where the additional beta from a high-conviction strategy would be best placed to generate outperformance?
In practice, these questions are more nuanced. It’s not so much a question of a long/short manager vs a small cap manager, more likely an equity-market neutral strategy vs a 130/30 strategy.
Which leads me to…
Step 3: Manager Selection
When choosing a core manager(s), we look for consistent alpha sourced from a consistent and disciplined investment process. We prefer investing with portfolio managers who own their own the business they work for, who invest exclusively in their own product and stay in their lane – investing and generating alpha in their areas of expertise and understanding.
At Seneca, we have a stylistic preference for quality and growth at a reasonable price, but whatever style or approach you choose, it should be demonstrated in a fund manager’s portfolio relative to the benchmark. In our specific instance, think along the lines of more earnings growth, higher return on equity, lower EV/EBITDA ratio etc.
Trailing returns are important, but we don’t, as many self-directed investors do, and select the highest historical returns over the last 1-, 3- or 5-year period. However, our process results in us (with the benefit of hindsight) regularly investing with managers who are consistently among the top performers in their specific peer group.
Information is power.
To conduct these sorts of comparisons properly, you’ll need access to a fund data provider as a start point. The major ones used by asset consultants and advisers in Australia are:
- FE Analytics / Zenith
- Lonsec
- Morningstar
Without reliable, accurate and high-quality data, you’re toast.
From those foundations, it’s about building up your own internal database of information gleaned from presentations and meetings with portfolio managers and analysts and then mapping those qualitative insights back to their specific portfolio holdings and actual actions.
We often uncover many of what I’d call, ‘the dirty little secrets’, of the funds management industry – the marketing spin fed to the public to justify higher fees. For example:
- funds marketed as ‘high conviction’ who clearly have no conviction (position size and quantity are similar to that of ‘diversified’ peers who charge less.)
- long/short funds who barely utilise their short-selling capacity (and when they do, it actually detracts from performance.)
- ‘active’ managers who just hug their benchmark (no discernible reason to pay the incremental fee load.)
- “quality” managers who talk about investing with “founder-led businesses” and how this leads to outperformance and somewhat ironically, do not own a single share in the funds management business they work for.
Common mistakes
Investors should be careful comparing ‘since inception’ returns across managers. Every fund has a different inception date and as a result, a different start point. Use specific date ranges to compare returns and avoid over-valuing those managers who fortunately started their fund just before a period of ‘easy alpha’ where even mediocre fund managers outperformed.
No active manager outperforms all the time… except Bernie Madoff.
Similarly, no active manager outperforms all the time, except Bernie Madoff.
Instead of only measuring a fund manager on if they’ve beaten their benchmark index, or if they’ve generated a high positive return, consider their results among peers. Outperformance in a given quarter, half or year may be particularly difficult for any number of reasons, but if your selected fund manager has done better than most of their peers, communicated clearly with you and stayed true to their strategy, you’re probably invested with the right people.
Finally, be cognisant of when you choose to invest. It’s not a portfolio manager’s job to make you money, they get paid (generally) to outperform their benchmark. If the market is down 15% from when you invested, you would have probably lost money regardless of which comparable fund you invested with.
While your timing has been unfortunate, this isn’t the fault of your financial adviser either. Nobody, and I mean nobody, can tell if the wider share market is going up, down, or sideways in the short term.
Fortunately, almost anyone can tell you where it is going in the long run and that, as well as a consistent application of a thorough and disciplined investment process is where you should be focused.
