The Art and Science of
Identifying fund-manager skill is a blend of art and science
To navigate often complex markets, we believe it is important to be able to employ the experience of skilled fund managers. Skilled managers do exist, and we focus our own skills, experience and efforts on uncovering those who we believe can deliver on their objectives for our clients over the long term. There is no correct or incorrect approach to active fund management, it’s more a case of matching the right approaches with the right skills.
Before we set out to find these managers, it is important to understand what makes up the returns of a fund. At the most basic level, fund returns can be divided into the market return, or ‘beta’, and a return in excess of the market, or ‘alpha’. Alpha, which may also be negative, can be regarded as a measure of skill. When we assess a manager’s skill we are analysing their ability to deliver positive alpha over the long term.
We are very mindful that longer-term outperformance (or alpha) will almost always come at the expense of short-term periods of underperformance and we cast our eye over the full market cycle when judging managers.
Typically, a greater degree of long-term outperformance brings with it a greater possibility of short-term underperformance. It’s often the case that past performance is not a reflection of future performance potential, and we have regularly seen top-ranked managers falling down the performance rankings, and vice versa. What we seek to understand is whether the manager’s alpha-generating ability is repeatable.
This can be boiled down to identifying and understanding a fund manager’s particular ‘edge’, and why this is likely to add value over the long-term. Equally important is to understand a manager’s area of competence, so we can determine whether they are straying from their core competency. We must truly understand what we are buying, and how it complements other portfolio holdings. Diversification across fund managers that have different ‘edges’ can help produce better and more stable long-term returns as well as reducing overall risk.
For example, we recently invested in a manager who experienced short-term negative performance in an environment that wasn’t rewarding his particular edge, playing to one of our core investment principles – going against the crowd. We maintained our confidence in his ability to deliver alpha over the long-term and saw this as a good opportunity to buy the fund at a reduced price. Subsequently, the fund has begun to produce positive returns from a market environment that has become more conducive to his particular approach and skills.