Fourth Quartile: the phrase that is supposed to strike terror into the heart of every fund manager. In essence it means that three quarters of the funds in its peer group have delivered better returns over that time period. Believers in the Efficient Market Hypothesis (that the market is always perfectly priced) would therefore assume that a fourth quartile fund has done something seriously wrong. Others, and that includes us, prefer Ben Graham’s view that the market is a voting machine in the short term but a weighing machine in the long term. Data from Barclays, Credit Suisse and Professor Jeremy Siegel convincingly proves that the stock market weighs dividends more than any other measure.
Let us remind ourselves of what has happened over the last year? The top ten performers in the FTSE 350 over the last 12 months include Avis Europe, Taylor Wimpey, DSG International. None are currently paying dividends and only one of them is forecast to pay one next year. Even after rising by 440% Avis Europe is still only valued at £248m. It is a tiny business and, on a price to book ratio of 4, a demanding valuation. Needless to say it is not held by The Munro Fund. Contrast it to Standard Life which the fund does hold. Over the last year it has fallen by 20% and is one of the worst ten stocks in the FTSE 350 index. It has a lowly valuation of 1.3 times book value and is paying out 11.8p a share in dividends giving it a yield of 5.7%. It is perfectly fair to say that holding Standard Life instead of Avis Europe has given a worse return over the last twelve months. But will that be the case for the next twelve? In the short term changes in capital values are important as the market reassesses its views on stocks. In the longer term though it is the income those stocks generate that is far more important.
Holding or not holding stocks is black and white. The grey area is how much a fund holds in a stock relative to the index. There are two large stocks where The Munro Fund differs substantially from the index; one is Vodafone and the other is BG Group. Vodafone makes up 4.79% of the FTSE 350 Index but The Munro Fund has a holding of 7.71%. A forecast dividend of 8.4p per share for its next financial year means it will be paying out £4.4 billion in gross cash dividends if the company pays out as expected. That means it will constitute 7.3% of the total £60.7 billion that companies in the FTSE 350 index are forecast to throw off in their next financial year.
In contrast BG Group is forecast to pay 14.1p a share to generate a gross cash payout of £475 million. That constitutes only 0.78% of that £60.7 billion total for the index. Today the market thinks those dividends from BG are worth a lot more than the dividends from Vodafone. That is why BG accounts for 2.36% of the FTSE 350 Index and trades on 3.1 times book value while Vodafone is only valued at 0.85 times book value. Put another way every pound of sales made by Vodafone is valued at £1.80 but each time BG takes in one pound of revenue the market values it at £3.50. No one really knows if investors are too optimistic about BG and too pessimistic about Vodafone. Trying to assess how much revenues or book values are worth keeps many analysts on both the buy and sell side happily engaged for long period of time. In the end though, the answer is always subjective. What we do know is that the magic of compound interest on dividends will probably give income investors a better return in Vodafone than in BG over time whatever capital value the market puts on their companies.
Such is modern life that the conference centre at Meriden subsidises the motorbike museum next door. Yet a walk around that museum is instructive for today’s fund manager. The museum has over 700 bikes, all British, mostly made in Birmingham and dating from the very beginning of the 20th century. What is truly staggering is the sheer range and diversity of designs that were produced around the fairly basic concept of two wheels and an engine. This variety was a direct function of the large number of manufacturers. As the man with the rag halfway through polishing several hundred bikes remarked “There was one for every letter of the alphabet”. It was not just Nortons and Triumphs or even less familiar ones like Vincent and Brough but names that are hardly remembered like Wooler and AJS.
Each manufacturer had its own special ideas and each model its own features. Some of them were truly bizarre like the one with twin back tyres. How would that corner? There were shaft drives, belt drives, chain drives, one cylinder, two cylinder, four cylinders, some in Vs, some squares and controls in all sorts of places. Today, save for two, they have only one common feature; none of them are in business now. A motorbike today from a major manufacturer will have a chain drive, probably a parallel twin layout and a control system that is common to all. Oh, and it will probably be Japanese.
In the end all consumers wanted was a bike that was reliable and reasonably priced. British bikes were idiosyncratic and leaked oil. Japanese bikes were reliable, well priced and did the job. At the finish consumers cared less about the complexities of the engine layout than the fact that the machine did what it was supposed to do: start, go fast, corner and stop.
What, you might wonder, has this got to do with fund management? Consider this. Most active fund managers today can be compared to those Midland manufacturers between the wars. Each is an individual, even if they work for a large firm. They all have their own approach and try and maintain a competitive edge over their rivals by having a secret recipe of how they build a portfolio. Little of it is written down and few fund management firms can even claim to have an in-house style. Indeed, if the media are to be believed, one well known firm contains two sharply contrasting views on the oil market; a bearish one from its equity fund manager and a bullish one from its bond managers. Fund managers could learn a thing or two from bike builders about brand management.
This wide variety of products is reminiscent of those bespoke, virtually handmade motorbikes from old middle England. Most of the time they do the job of giving investors the equity market returns they are seeking. However, those returns can be a bit lumpy and the ride can be wild. Sometimes, like New Star, they crash spectacularly. They are in the great British tradition of amateurism.
Motorbike manufacturing changed when pricing power moved from the producer to the consumer. Fund management is fortunate that prices are still set by the producers, not by the consumers. But, as with airlines, that situation is changing and pricing power is moving to the consumer. Part and parcel of that process is the growing realisation that what investors want is a cheap reliable product that delivers the returns of the asset class.
Motorbike buyers in 1929 were offered a plethora of choices about the design of the motorcycle. In the same way investors today have to choose from a bewildering array of active funds but, unlike bike buyers of 70 years ago, they have very little data on which to base their choice. With little information on how the process at fund A differs from that of fund B intermediaries have to rely on the simple output data of performance. That is like comparing a 1,000 cc square 4 with a single cylinder 125 cc. Both might do 60 mph but they achieve it in vastly different ways. An informed buyer could form a judgement as to which might be more reliable.
Apart from historic data like TERs, tracking errors and a few other ratios such information is lacking for active funds. It is only the new breed of modern tightly defined passive funds that define exactly what they do and how they do it. For the investors who simply wants a fund that does what it says on the tin, delivers the returns of the market cheaply and reliably, passive funds are the only solution. Of course, there will always be a demand for the sporty bike and the sporty fund. But both are uncomfortable to ride and can bring you out in a cold sweat. For the serious long term rider and the long term investor reliability is the key. To get that you need to know exactly what you are buying.
What’s the difference between buying shares and buying collective investments? In theory there should be none, but in practice it is clear that very different processes are at work.
A share represents part ownership of a company that has its value determined in the market against certain measures such as sales, profits, cash flow and book value. Moreover, investors can make an assessment of the prospects for that industry whether it is making steam trains or wind turbines. Using this data an investor can form his own view of the valuation and determine if it is cheap or dear and trade accordingly. He may also seek social proof from other investors in magazines and websites that his views are shared by others. The best proof of all is to see the share price going up providing clear evidence to confirm that his view is correct and acts to reinforce his decision to buy.
Investing in a collective investment is more difficult. For active funds it represents the amalgamation of two views, one about the market and one about the manager. Few funds provide much data to assist with valuation, such as aggregate ratios for price to earnings, sales or book value. If it is an income fund the yield can provide a guide and maybe that is why these funds have proved so popular in recent years. Having at least one tangible measure is better than nothing. Even so this data needs to be treated with caution if the fund invests outside its core market and or uses different asset classes, such as fixed income.
For many funds there is no such data. That leaves investors relying on the concept of social proof, the actions of others, to provide the evidence they need to make a decision and buy a fund. In fact of course the return of any fund is a product of two factors; the movement of the underlying asset class and the performance of the fund relative to it. The relative movement of the fund itself is usually more a function of the amount of risk a fund has taken rather than a measure of stock picking skills. High beta funds do better in a rising market and worse in a falling market. Selecting a fund with the beta you want is usually a lot easier than trying to determine if we are in a bull or a bear market. Right now high beta funds are flying after a six month rally in the stock market that has pushed everything up, especially growth stocks.
Naturally many of these funds now appear at the top of performance league tables. But is now the right time to invest in them? That is a difficult call for the adviser. He has to determine the likely course of the market in the short to medium term and then decide how much risk to take on. Does he want to beat the market, but take the risk of a double whammy if the market corrects and his high beta fund falls even more? Or does he recommend a fund that only does well, in a relative sense, when the market is weak or treading water? While the latter may not be instantly appealing it has been shown over time that shares with lower valuations consistently provide better returns over the long term than expensive ones.
It might go against the grain to select funds that have underperformed in this rally. But stockbrokers right now are sifting through the market to see which shares have been left behind in this recovery. The same logic applies to funds. If a fund can demonstrates it offers the same exposure, at a lower valuation, then there is a good argument for making the switch. There is no reason to rely solely on social proof to choose funds when there are data out there to prove they are cheap and less volatile than others.
Few people in March expected the FTSE 100 Index to be within a percent of so of 5,000 at the end of August. The mood then was one of uniform bearishness even though most observers agreed that the market was cheap. While it is true that some sages, like Buffet and Bolton, were calling the bottom of the market they had said the same six months earlier. The problem with forecasting is that you need to get it right every time.
As a tracker fund we don’t make forecasts.
All we offer is a simple, transparent and cheap vehicle for investors to get equity exposure. And, as this rally has demonstrated, no one quite knows when equities will take off. What is obvious is that anyone without equity exposure six months ago has been denied a 30 to 50% gain on part of their portfolio. If the average yearly return for equities is about 6% that could mean that the last six months have given us the returns of the next five years already. Then again, will the market see 6,000 before it sees 4,000?
No one knows.
Clearly, it is sensible to maintain some exposure to equities; but how? Traditionally it was through active management but the volatility from individual stocks is high. Trackers reduce that risk through diversity. The problem with cap weighted trackers is that as shares rise the biggest gainers become a larger component of the index. That means they attract a bigger slice of the next injection of capital into the market and a strong positive feedback effect is established that makes big companies even bigger.
Consequently cap weighted funds are always overweight expensive shares at any point in time.
That might seem a little odd and it merits a brief explanation. Although we will never know for sure which stocks are expensive the example below demonstrates the difference between weighting stocks by price compared to a fundamental measure.
Assume the components of a stock index have aggregate earnings of £100m and the whole market is valued on a PE ratio of 10. Therefore the total market is valued at £1,000m. We might not know exactly which stocks are cheap and which are expensive. But let’s assume half the stocks have an above average PE of 15. That means the other half must be valued at 5 times earnings. It follows therefore that the expensive half of the market is valued at £750m and the cheap half at £250m. Consequently any cap weighted index fund will have 75% of its assets in the expensive stocks and only 25% in the cheap stocks. While this effect is reduced when the range of valuations is lower, it will always be present.
History tells us that cheap stocks outperform expensive stocks over time, yet the cap weighted index fund is underweight in them. In fact, because such a fund is overweight expensive shares it has a higher PE ratio than the market, in this example it has a PE ratio of 12.5; a quarter more than the index itself. You might be buying £100m worth of earnings, but doing it this way you are paying 25% more than the average and that is bad for long term returns.
Dividends are a proxy for earnings and that is why the fundamentally weighted Munro Fund has a lower valuation than the market. While the FTSE 350 is valued on a price to book ratio of 1.84 that of the fund is 1.69 and on price to sales the figures are 0.98 against 0.85.
No one can accurately call the direction of the market. But maintaining an exposure to it makes sense. Doing that through a low risk vehicle that is cheaper than the market makes even more sense.
Last week the FSA released its consultation paper on the Retail Distribution Review which is aimed at improving the quality of advice delivered by financial advisers. It seeks to achieve this largely by banning the use of commission as a marketing tool in the expectation that this will reduce prices and eliminate the bias towards high commission paying products.
Such a single track approach overlooks other deficiencies in the existing market place, the largest of which is the paucity of data to assist intermediaries in assessing the quality of funds. Even though it is widely accepted that past performance is no guide to future returns the industry and the media largely concentrate on returns over various periods. Little mention is made of how much risk is incurred to make those returns. It is easy for a fund to increase its risk by, for example, taking large positions in small stocks. But unless it is rewarded by having better returns than its peers then the fund has failed to do its job. Even if such a fund does match the returns of the index or its peers it has delivered it with more risk than was needed. That makes it lower quality than a fund that can deliver the same returns at less risk.
Gatekeepers at the large networks and private client managers have access to a great deal of data from companies such as Lipper and Morningstar. This gives them the information they need to assess the riskiness of funds. But not all intermediaries have this data and most clients are not familiar with the measures. Moreover, the trade press totally ignores such data, preferring to focus on historic returns and calls on the market, sectors or stocks.
Contrast the data presented in the back pages of financial magazines with that in car magazines. A prospective car buyer can easily find out how fast a car goes and its acceleration time. More importantly he can also discover what the fuel consumption is, how many seats it has, how much luggage it can take, an estimate of running and insurance costs and how safe it will be in a crash. Consumers looking to invest as much as they might spend on a car, or considerably more, are curiously unquestioning about the nature of the investment vehicles they might use.
All funds have data such as total expense ratio, tracking error, alpha, beta and information ratio. Why is this data not disclosed more widely in league tables or when funds are described by journalists? If the FSA really wants to increase the quality of advice it should demand that all funds publish a lot more data, such as tracking error and excess return. Then it will be clear exactly how much risk a fund has incurred and whether it was worth it. That way consumers will be able form their own judgements of the quality of advice and products they are being offered.
Managing money is easy; doing it better than others is extraordinarily difficult because there is simply so much competition. A measure of that competition is the size of the IMA UK All Companies sector in which The Munro Fund sits. It contains 354 funds and over the year to the end of April the average return was a decline of 26.3%. That sounds pretty awful and the last twelve months have certainly been one of the most painful for investors in recent decades. A demonstration of just how bad is the 26.9% decline in the FT All Share Total Return index. On the face of it then the average fund did well to beat the index, especially when we remember that fees will probably reduce average returns by at least one or two percent over a year.
But how can the cohort of funds be better, on average, than the benchmark it is measured against? After all this is real data, not opinions subject to the Lake Wobegone effect, the town where every child is above average. Every fund manager might think they are above average, but performance data is not subjective. The answer is that a great many of the funds in the UK All Companies Sector include stocks that are not UK listed. To make matters more complicated some funds derive significant returns from using derivatives. The manager of one of the highest profile funds in the UK admitted to me at a recent conference that a fifth of his return came from using derivatives. How you compare that with a conventional long only fund beats me. However, once we understand that we are dealing with a heterogeneous group the reason for the discrepancy in returns becomes obvious. There will always be some fund at each point in time that has the right mix to perform better than its rivals.
There is an obvious incentive for a fund manager to pinch outperformance against his peers by selecting stocks that his rivals don’t own. Measuring yourself against the UK index when up to 20% of your fund is in foreign stocks is a simple way of pinching beta from another market and claiming it as alpha in your own.
That is the reason the performance data we quote for the Munro Fund is not expressed in quartiles or assessed in relation to its peers through IMA sectors. This fund only contains stocks in the FTSE 350 index. Comparing The Munro Fund against funds that do all manner of other things, like using derivatives or overseas stocks, is akin to comparing a sports car to a family estate. No car dealer would rank the performance of a two-seater against a load-lugger without factoring in the different tasks they might be purchased for. Unfortunately, no such discrimination takes place within the UK All Companies sector. Only capital gain is measured.
Cynics might think we avoid the comparison because it reflects badly on the fund. That is not the case. This page on Trustnet shows that the fund is in the top quartile in performance but, equally as important, in the top quartile for risk and risk adjusted returns. In other words three quarters of our competitors are taking more risk than us but are not being rewarded for it. Of the funds that are ahead of us one wonders how many are true long-only funds limited to UK listed stocks and eschew derivatives.
The only performance data we quote is against the FTSE 350 Total Return index. That is our benchmark and the only relevant measure is how well we do in comparison. It is of course impossible to invest directly in the index itself, but we hope this fund is the next best thing.
The last month has seen a substantial rally in share prices. These capital gains are encouraging and give us a warm feeling. Nevertheless, the reality, and the investment philosophy of this fund, is that the bulk of our equity investment returns comes from dividends and the reinvestment of dividends. The Barclays Equity Gilt study says dividends generated 90% of the return from UK equities since 1945. Société Générale, in another study, asserts that even over a short period of five years that dividends and growth of dividends accounts for 80% of returns.
Theoretically then the variations of the capital value of that income stream should be of only cursory interest to the long-term investor. In much the same way a boat owner is only mildly curious about whether it is high tide or low tide as long as his boat is still afloat.
Even so, changes in indices are fascinating. What is curious is the sharp increase in the small cap index. A rise of 42% since its low on the 3rd of March leaves that index on a yield of 4.7%. The FTSE 250 index has risen slightly more with a gain of 43%, although that is since November, giving it a yield of 3.7%. It is the FTSE 100 that is the latecomer to the party with a rise of only 24%. Nevertheless, it still yields more than it is smaller siblings at 5.0%.
The Munro Fund weights dividends by volume not price. So we find it interesting that the value of the £944m of dividends from the small caps and the £5.1b in dividends from the mid caps has risen twice as much as the £55b in dividends from the large caps.
Given that the prospects of all dividends can never be known with any certainty one wonders why the market has decided that dividends from small and mid caps are now more prized than those from large caps.
Over the last two years a good argument could be made for the 40% fall in the FTSE 350 as forecast dividends have fallen 18% from £74b to £61b with doubts there could be worse to come. That reflected a fall in both the volume and the value of dividends.
Although estimates are still slipping it seems that the worst of the dividend cuts have been made. Even so it is hard to envisage substantial increases in dividends from here. In which case there is not much of an argument for paying more in anticipation of higher payouts. What the market seems to have decided is that those dividends, while smaller, now have a higher value. What is unclear to us is why the smallest cohort of dividend payers has been re-priced more than the larger ones. Are small UK companies really offering more secure income than large diversified internationals?