With global markets hitting record highs as AI ‘eats the world’ it comes as no surprise that managers who have missed the boat are increasingly coming under pressure to stop the bleeding.
Passive funds that track the broad market own every high-flying tech stock in proportion to its weight in the index. Meanwhile active managers choose stocks based on their own investment beliefs and process. If you owned the AI stocks you look like a genius, if not, chances are your investors are making mutterings of dissent if not actually redeeming their investments.
The closet indexer’s trap
That is the brutal reality for active managers. If you underperform your benchmark sooner or later, you will no longer be in business.
This is the main reason active managers become closet index trackers where they hug the benchmark, even if it means they will almost certainly lag after fees. To paraphrase John Maynard Keynes, it’s better to fail conventionally than to succeed unconventionally.
This is not a hypothetical scenario. With global equities delivering 16.7% p.a. over the past 5-years in NZ dollar terms, some of the largest and best regarded KiwiSaver managers are now reporting multiple years of relative underperformance. The short-term solution is to buy the AI stocks and neutralise their underweight exposure.
By definition, to beat the market you must be doing something different to the market.
But by hugging the index more closely you reduce your ability to generate the outperformance that built your businesses in the first place. As an investor you are left with the prospect of passive returns less the active manager fees.
Fundsmith blinks
The recent case of UK manager Terry Smith provides a stark example of the pressure managers face when they lag their benchmark. Smith’s eponymous firm Fundsmith is something of a UK institution, famous for his three-part investment strategy: buy good companies; don’t overpay; do nothing.
And it worked a treat. As the following chart shows, Fundsmith outperformed the MSCI World Index by more than 260% in its first 10-years. Five years later and it has given it all back and is currently barely ahead since inception.
Fundsmith’s assets peaked at almost £29 billion in 2021, propelled by years of exceptional performance and heavy inflows. Less than five years later, they had fallen to just less than £12 billion. The timing matters: while the fund has returned 13.1% p.a. since inception, an investor who arrived around the peak has earned less than 1% p.a. since then.
In a recent note Smith announced enough was enough, abandoning his signature “do nothing” buy-and-hold approach while bemoaning the difficulty for active managers in momentum-driven markets amid an AI boom.
“We run open-ended funds, and you can and increasingly have been taking money out, we suspect mostly to join the exodus from active to passive, or possibly to invest in managers who profess that they understand quality better than we do. They may be right, or they may just be closet momentum investors, which will be fine until it isn’t. However, there will be little point being proved right about the dangers of passive or momentum investment after our Fund has closed.”
Once renowned for its low turnover, often less than 5% per year, in the first half of the year Fundsmith has changed more than 50% of its portfolio. Out went a host of “quality compounders” and in came stocks with stronger recent momentum including several beneficiaries of the AI/technology thematic.
While it is far too early to see if the changes turn the performance around, if anything it will be more interesting to see the effect it has on fund flows as institutional allocators hate nothing more than managers who change their strategy, or “style drift” as it is known in the lexicon.
GCQ doubles down
Closer to home, a manager that shares much of Fundsmith’s “quality growth” investing DNA is Australian firm GCQ.
While being a much younger firm than Fundsmith, GCQ (Global Concentrated Quality) run by Doug Tynan, attracted strong investors inflows after beating its benchmark by nearly 10% per year over its first three years. A horror 12-months later, during which it trailed the global index by more than 37%, the fund is now behind its benchmark since inception.
Unlike Fundsmith, GCQ is sticking to its guns and if anything has been doubling down over recent months, adding to positions that have been sold off. With their underlying companies continuing to deliver strong earnings growth, GCQ are very much of the view that the AI trade is distracting investors from quality businesses. going as far as saying
“we have never seen more valuation upside than we do today for the companies in our portfolio.”
Ultimately, GCQ believes it is only a matter of time before the focus of the market shifts and recognises this too. Fortunately for them they have time on their side, as with less than a year of underperformance the pressure of outflows hasn’t yet forced their hand.
While both Fundsmith and GCQ can be said to be “quality” managers there is a relatively limited crossover between the two funds’ holdings. Where it gets interesting though is several instances where Fundsmith has been buying stocks that GCQ has been selling and vice versa, creating something of a natural experiment.
Whether it be Fundsmith or GCQ who is proven correct, only time will tell. What we can say is that as allocators we prefer managers who aren’t beholden to a market index, because the manager who never has to chase a benchmark can never be forced to abandon their edge to catch it.
The discipline we look for when selecting managers on behalf of Saxe Coburg clients, is the ability to hold a position when the market disagrees with you, not just when it’s easy to.
If you’d like to discuss the topics covered in this article, please get in touch with Mark or Sam or contact us for a discussion on how we could support your wealth journey.
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