Last Monday, I took a look at why it makes sense to favour passive funds over active funds as an investor.
They're cheaper, easier to understand, and they generally perform better. It's as simple as that.
But let's say that you still want to invest with an active manager. How do you improve your odds of finding a good one?
First things first – understand why you are rejecting the passive option
If you decide that you want to invest in an active fund rather than a passive tracker, then the first step towards making a sensible choice is to understand what your decision implies.
A passive tracker gives you the option of following the underlying market cheaply. If you reject that option, then it implies that you believe that there are investment strategies that will deliver better returns. And you're willing to pay for that strategy to be put into action on your behalf.
That's not necessarily a bad idea, at least in theory. Most major indices are based on market capitalisation. The more valuable the company, the higher up the index it goes.
In other words, when you buy a typical tracker fund, you are committing to a strategy that adds money to stocks that are already expensive, and sells out of those that are becoming cheaper. That's the opposite of "buy low, sell high". It might not always end in disaster, but it's not the most sophisticated way of doing things.
Question 1: What's the plan?
Well, clearly, first of all, you need to find someone who has an alternative strategy. An active fund managers is making a promise to you. That promise is: "Stick with me, and over the long run, we'll beat the market." Your first question should be: "How?"
Look at some of the best-known and most successful fund managers: Terry Smith of Fundsmith, Neil Woodford of Woodford Investment Management, Nick Train of Lindsell Train, James Anderson of Scottish Mortgage. They all have very clear, easily articulated investment strategies, and they stick to them.
Train buys strong brands with high barriers to entry. Woodford focuses on value and on exploiting the freedom that his reputation affords him to buy and hold for the long run without his investors bailing out when hard times hit. Anderson is a believer in transformative companies and is happy to pay up for the likes of Amazon or Tesla or Facebook – it's a very different approach to the ones I generally favour, but it has worked well so far.
The point is, each of these basic strategies can be explained in less than a paragraph. When you buy these funds, you know what you're getting.
So if you can't quickly explain to a non-financial friend how the fund manager you are entrusting your money to will deliver the goods, then you shouldn't buy their fund. Or at the very least, you need to do more research.
Question 2: Nice plan. Are you sticking to it?
Conviction matters. It's no use having a decent-sounding strategy if it's diluted beyond recognition by efforts on the part of the manager to hedge their bets.
This is where you have to take account of one specific risk faced by fund managers. It's one that doesn't directly affect you as an investor, but its indirect effects can certainly crush your investment returns. It's "career risk".
Career risk refers to the fact that, from a job-security point of view, it has always been better for a fund manager to mildly underperform the market consistently, than to take bold bets. This is why "closet trackers" (funds that basically track the market without being upfront about it) are so widespread.
It's not necessarily deliberate obfuscation on the part of the manager – it's just that, while they believe they have a strategy, they lack the confidence to follow it through to its logical conclusions. And all you end up with is a fund that – after costs – almost can't help but lag the market all the time.
It's hard to blame such managers. Even if your bold, high-conviction bets pay off, and you have a blinding run of it, gratitude has a very short half-life, as a wise man (well, Thomas Harris, the inventor of Hannibal Lecter, actually) once wrote. The truth is that at least some of your investors will be calling for your head after a couple of dodgy quarters.
So it takes guts, self-belief, a certain amount of egotism, a rhino hide, maybe a touch of misanthropy, a considered disregard for others' views – in short, a high conviction in your own ability to beat the market – to ignore career risk and stick to your beliefs.
How do you tell if a fund manager has conviction? Look at the holdings in their fund, and the size of the bets taken. Anderson's top ten holdings account for more than half of his fund. For Train, the top ten accounts for nearly three-quarters of his portfolio.
When managers talk about having conviction, and then it turns out their portfolio has upwards of 70 holdings of bog-standard stocks, you have to question exactly what all those extra stocks are doing there.
Question 3: Do you eat your own cooking?
Everyone needs to invest for the future one way or the other, even if you're the happy owner of a final salary pension. So what's the manager of your chosen active fund doing with their own money?
There's really no excuse for a manager not to be invested in their own fund. If they're investing with someone else, or in a passive fund, then they clearly think that approach is better than their own strategy. In which case, why should you invest your own money with them?
So those are three good questions to ask of any active fund you want to investigate further.
Next Monday (or Tuesday, if I think we have to chat about the Italian election results next Monday), I'll take a look at some of the good signs and some of the red warning flags to watch out for when hunting for potentially market-beating active funds.