The traditional fund management industry continues to come under fire from advocates of passive market exposure. The arguments in favour of their passive counterparts are numerous and, for the most part, valid. These include the fact that passive funds are cheaper, and, more pertinently, whether active fund managers can consistently outperform their relative market index tracker – hence justifying the higher fees.
Unfortunately, the reality is that over the past ten years the average actively managed fund in the IA Global sector (which includes around 300 funds) has failed to keep up with its MSCI World index benchmark, while also underperforming their relative ETFs and passive index trackers.
The scope of this article, rather than to highlight the above, is to share Blue Whale’s thoughts on why this is happening. Additionally, we will take this opportunity to share our thoughts on what can be done to tackle this going forward.
Why is it getting harder to beat the market?
Few will disagree that the market is becoming more efficient. Understandably, this has weakened the case for active management. However, rather than coming up with real solutions, many firms have resorted to piecemeal, reactive measures – like cutting management fees, to appease disgruntled investors. Although lower fees are certainly a good thing for investors, this is not getting to the root of the issue and will only delay the inevitable should underperformance persist.
To delve deeper into the why, this is quite simply that in an increasingly globalised and interconnected world, new data and information is being factored into valuations more quickly. Until recently, firms could rely on the exclusivity and access afforded to fund managers. As regulation has become stricter and more far-reaching, and information has become more readily available via the internet, it has become harder for active fund managers to beat the market.
Another factor to consider is that the augmented oversight has comprehensibly increased transparency in the industry. This means that proprietary information is becoming harder to come by.
Slow response to changing norms
This increased efficiency, albeit a major challenge to our sector, is only part of the problem. In our view, the real issue is that the active fund management industry has been slow to react, opting to rely on traditional techniques and practices to tackle this new reality. Alas, for a variety of reasons, these have not been delivering the desired outcomes for firms and investors alike.
A case in point is corporate access; the widely publicised practice of regularly meeting with company management. This has been a key aspect of a fund manager’s analysis for years. Despite it being useful in some cases, our view is that it has rightly been rendered far less valuable in terms of getting an edge in the large market cap segment of developed markets. In addition, regulators have been stamping down on selective disclosure that gave some managers an unfair advantage. Put simply, company management can’t tell you anything significant that isn’t already in the public domain and rarely shift from the script.
The role of sell-side research
Sell-side research has become increasingly generic, seeking to appease a variety of underlying clients with different angles and perspectives on the same stock. There has been more focus on whether companies will beat or miss quarterly targets, with thought pieces about longer-term perspectives dwindling away.
Furthermore, availability of this research used to be restricted those in the know, or firms with the means of gaining access. Its scarcity allowed fund managers to gain that edge over their competitors – its now relative ubiquity means that the same information is shared market-wide.
With the implementation of the MiFID II Directive last year, the circumstances in which funds can pay for research provided to managers by brokers have been severely restricted. The subsequent lower demand has caused seasoned analysts to exit sell-side research altogether, leaving fewer, more junior analysts to cover the stocks. The outcome – a decline in the provision and quality of sell-side research.
Ease of access to valuation data
Sell-side consensus forms the basis for widely referenced stock valuation metrics and is readily available on Bloomberg or the likes of Yahoo Finance. The relative ease of access to this data means that these headline valuations are being utilised to determine value opportunities. A potential issue with this is that it has been derived with a shorter-term focus, typically one to two years out. It is important to keep this in mind when considering this data.
Threat or opportunity?
To recap, the efficiency of the market and access to information is making it harder for fund managers to outperform their passive counterparts. However, this does not necessarily have to be a negative development for the sector. It creates an opportunity for fund managers to adapt to the new conditions and to differentiate themselves from the rest. Investors should be looking out for the managers that are able to take this on board.
At Blue Whale we are firm believers that this is an opportunity for the asset management sector to embrace change. Our take on how this can be achieved revolves in some way around the elements below:
- Increased resources dedicated to in-house research and analysis
- Internal financial modelling and proprietary valuation metrics
- Adopting a genuinely active, valuation-driven approach to portfolio management
Conducting in-house research
When analysts conduct their own research, [from scratch rather than re-hashing multiple brokers’ output], they are better placed to formulate an in-depth understanding of the stocks they track. It is imperative that the internal thought process and subsequent conclusions are not simply being guided by a consensus view.
Everyone can access the relevant primary information in real-time. It is what is done with it that will determine the outcome. Scouring through annual reports, listening to conference calls and management updates, scrutinising management teams, forming a thorough understanding of the sector and market dynamics – these are an integral part of stock analysis. Spending considerable time absorbing this information, learning the intricate details about the companies that fall within a fund’s investment universe – these practices need to become the norm in our sector.
Proprietary financial modelling and valuation metrics
Another way in which asset managers can possibly create an edge for themselves is by increasingly building their own financial models and developing proprietary valuations metrics.
Financial models developed by sell-side analysts will tend to be rather short-term in their outlook, hence obsessing over quarterly updates. Rather than relying on the inputs, metrics and conclusions developed by the external parties, investment teams can set themselves apart by making their own forecasts and formulating their views based on a stock’s medium to longer-term outlook. This should increase an active fund’s chances of beating the market over time.
Genuinely active management, valuation driven approach
The outcome of increased market efficiency is that the intrinsic value gap, which fund managers have historically sought to exploit, seems to be dissipating far quicker than in the past.
Adhering to a genuinely active, valuation driven approach to portfolio construction increases the likelihood that fund managers can spot and take advantage of these opportunities. This should, in turn, increase the chances that they can deliver consistent outperformance. In the present environment, this will only come about as a result of thorough analysis and a profound understanding of the stocks within a fund manager’s universe.
The Blue Whale approach
At Blue Whale we welcome the challenge. We do not believe that increasingly efficient markets should necessarily spell the end of traditional active fund management.
Our conclusion – should actively managed funds adhere to a combination of the above-mentioned elements, even were they to run a diversified portfolio, they can potentially outperform their passive counterparts. In our case, we combine the three with a concentrated, high conviction portfolio of 25 to 35 stocks. We feel confident that this, along with our meticulous research and stringent investment criteria, places us in an ideal position to consistently achieve significant outperformance of the market.
Despite our above affirmations, we are cognisant that our approach is by no means the only way to tackle the new reality. Yet, we are optimistic that, at the very least, we are moving in the right direction.
Stephen Yiu is chief investment officer of Blue Whale Capital and manager of the Blue Whale Growth fund. The views expressed above are his own and should not be taken as investment advice.