How do you choose market-beating active funds that will outperform for decades to come? While there are some guidelines you can follow the surprising truth is that this is ultimately a matter of faith. Here we compare three UK active funds which we believe have the potential to outperform long-term: Fundsmith Global Equity, Lindsell Train Global Equity and the Vanguard Global Value Factor.
No British Buffett
The US investor Warren Buffett starts each of his investment newsletters with his annual performance versus the S&P 500 over the 53 years since he started his fund Berkshire Hathaway. His average performance has been 21% per year versus 10% for the S&P 500, an outperformance of 11%.
The UK is home to some of the best money managers in the World so it seems reasonable to assume that we have some of our own Warren Buffetts. However, it is difficult to find a UK fund that has (a) been managed by the same person for more than twenty years, let alone 50 years, and (b) find performance statistics for those funds. We can assume that if a fund manager in the UK had a Buffett-like record they would be shouting about it, so my conclusion is that no such fund exists.
There's another reason that I included the graph above. Notice how the size of outperformance gradually diminishes over time as the fund grows. That's because small stocks have the greatest capacity for growth and huge funds can no longer invest in small stocks. It therefore gets more difficult to beat the market by a large amount as a fund grows.
Who runs the fund?
The key performance driver for any fund is the management. For the three funds I have chosen the managers are:
Terry Smith (age 65 years)
Michael Lindsell (age 58 years)
Nick Train (age 59)
James Bullock (age 35)
A set of rules implementing peer-reviewed research on market-beating stocks
Terry Smith has shown the ability to choose stocks that outperform the broader market, and to do so consistently over many years. Although Fundsmith was founded in 2010, Terry Smith ran the Tullett Prebon pension fund along the same lines as Fundsmith Global Equity and this was reported to have returned an average of 14% annually from 2003 to 2010, a period that spanned the 2008/9 financial crisis. The Head of Research at Fundsmith is Julian Robins who is responsible for identifying and monitoring the list of shares for inclusion in the portfolio and who also plays a central part in the stock selection process.
Michael Lindsell & Nick Train have a strong track record since Lindsell Train was set up in 2011. James Bullock was promoted to Portfolio Manager in 2015 as a third fund manager for the Global Equity fund. Michael Lindsell has a great deal of experience with Asian stocks, particularly Japanese stocks, and this is reflected in the high regional allocation to Japan in the fund. Lindsell also runs the Lindsell Train Japanese Equity fund. Nick Train's background is more in global equities.
Vanguard Value uses an algorithm, illustrated above, to select stocks that are trading at a low price compared to their modelled value. Vanguard combines stock "cheapness" assessed using three models. Stocks are then ranked according to their value and the highest scoring stocks are incorporated in the fund. While there is no fund manager in charge of the fund, people from Vanguard's Quantitative Equity Group are responsible for developing and maintaining the rule-based funds. The quant team has existed for about 30 years and is currently led by John Ameriks.
What happens when the manager retires?
Fundsmith is very much dependent on Terry Smith who is now 65 years old. Young investors who want to invest over a long period of time may have concerns about Fundsmith's succession plan and whether the new managers will be able to implement Terry Smith's approach. However, Smith says in shareholder meetings that Julian Robins, head of research, does most of the day-to-day work on the fund and is likely to take over when Terry Smith retires. However, this has to be taken on faith, the true test of whether this is true will be actual performance.
Lindsell Train What I like about having more people running the fund is continuity. If something were to happen to one of the managers then the fund would continue to be run along the same lines. Also having young blood in the form of James Bullock ensures continuity. This is a consideration because Lindsell or Train are both pushing 60. If Bullock were to take over he would probably like to be running James Bullock Global Equity and, as often happens, may leave to set up his own fund in his own name.
Vanguard Value is not run by a human portfolio manager, instead it sticks to a set of investing rules that are automated and developed by Vanguard's team of quantitative analysts. The fact that the portfolio is run by rules means firstly that it's not necessary to pay a human fund manager to make day-to-day decisions about purchases and sales, and secondly that the fund could be around for a very long time as it is no longer limited by the timespan of a human career.
Fundsmith favours companies which generate a high return on capital employed (ROCE). ROCE measures how efficiently a company uses the capital it possesses to generate earnings (profits). For example an ROCE of 50% means that for every dollar of capital employed to run the company it generates about 50 cents of profit. This profit can either be returned to investors as dividend or ploughed back into the company to organically grow future earnings. Fundsmith likes companies that can reinvest their earnings at similarly high rates of return so ROCE does not fall. Fundsmith avoids companies that have too much leverage, or debt, as this poses a threat to the business. Fundsmith chooses companies it thinks are resilient to change, particularly technological change. Once Fundsmith buys a company it tends to hold it for a long time, reducing trading costs. Terry Smith jokes that his approach can be summarised as ODD: Only invest in good companies, Don't overpay, Do nothing.
Lindsell Train Lindsell Train like companies with brands or franchises that have been around for a long time, decades or even centuries. Their stock picks also have to satisfy criteria of longevity and sustainability into the future. These companies have "valuable and unique intellectual property whether it be brands, content or marketplaces". They build theoretical models of a company's value using "a variety of approaches, the most important being a discounted cash flow calculation". Like Fundsmith they hold stocks for as long as possible to reduce transaction costs. They say "we are extremely reluctant to sell it, except on a significant breach of our valuation target or when we realise that the premise for the investment is no longer valid. This reflects our conviction that owning great companies for the long haul makes sense and that transaction costs are a tax on our clients’ capital".
Vanguard Value The stocks in Vanguard Global Value Factor are drawn from an investment universe drawn primarily from shares in the FTSE Developed All Cap Index and the Russell 3000 Index. Vanguard's quantitative model uses a rule-based active approach that aims to assess the factor exposures of securities, favouring equity securities which, when compared to other securities in the investment universe, have lower prices relative to their fundamental measures of value (based on measures such as price-to-book or price-to-earnings ratio, estimated future earnings and operating cash flow). This value measure has been shown in a large body of peer-reviewed academic research to be a component of long-run stock market returns.
Fundsmith's annual performance is shown versus the iShares MSCI World ETF below. It has beaten that fund's performance in five out of the last seven years. The two years of underperformance (2013 and 2016) were years where MSCI World had a very strong rally and the underperformance was small in those years. In contrast the years of outperformance the size of the outperformance was often large. The end result is extremely strong outperformance of MSCI World over this time period of 18% on average each year since 2011 whereas iShares MSCI World returned 12%.
Lindsell Train also outperformed iShares MSCI World five out of the last seven years. 2016 was a particularly bad year for underperformance (-8%). Overall Lindsell Train has returned 17% on average each year since 2011 whereas iShares MSCI World returned 12%.
The inception date (the name for a fund's birthday) for Vanguard Value was December 9th 2015 so we don't have much historical data for comparison. The returns of Vanguard value versus the other two funds are shown below. For the two full years we have in 2016 the return of Vanguard Value was 44% (iShares MSCI World +30%) and the fund returned 9% in 2017 (iShares MSCI World +12%). Including 2018 the three funds are quite close with Fundsmith returning 71%, Lindsell Train 73%, and Vanguard Value 62%. We'd also have to subtract the fee for Vanguard which reduces its return to 61% (the other two are already net of fees).
It's important to remember that the outperformance of value stocks, which Vanguard Value tries to capture, is based on academic research which spans extremely long periods. For example a study by Dimson, Marsh and Staunton in 2017 showed that over the 61 year period from 1955 to 2016 UK value stocks generated an average return of 16.0% compared to 12.1% for the UK market overall. For the US data stretch back to 1926 and over this 90 year period value stocks returned 12.9% versus 9.8% for the overall market. In this paper they also showed that momentum outperformed in the UK and globally. Sometimes the value factor falls out of favour, such as during the 1990s as the tech bubble inflated. After the tech bubble popped, however, value came back into vogue. Another period of value underperformance was 2007-2016 when growth was favoured over value.
Both Fundsmith Global Equity and Lindsell Train Global equity have very high concentration risk. This means they have deliberately focussed their portfolio in just 20-30 stocks in order to boost their return above their global benchmark. They both argue that this is not a problem because all the stocks they own are "good" companies. By "good" they mean that their published accounts show they have sound finances and their analysis suggests they will continue to grow their earnings and share price. But this leaves them vulnerable to unknown unknowns: fraudulent accounts, trade wars, disruptive technologies... Any of these could hit an entire sector and could severely impact an undiversified portfolio. Vanguard Value has over 1,000 stocks in its fund and so does not have the same concentration risk as the other two funds.
Concentration risk for the three funds is illustrated in the graph below which shows the top ten holdings of each fund as a percentage of the whole portfolio. Fundsmith's top ten share holdings make up 47% of the portfolio, Lindsell Train's top ten is even more dominant at 58% and Vanguard Value's top ten make up an insignificant 4% of the portfolio.
Manager risk is the risk of a fund losing its key portfolio managers. These team members either leave to chase better opportunities or set up their own fund, or they may be retiring (voluntarily or involuntarily). Of the three funds Fundsmith probably has the greatest manager risk because it relies most heavily on one person, Terry Smith. Lindsell Train has mitigated its manager risk by including the younger James Bullock on the team but it would still be a blow to the credibility of the fund if either Lindsell or Train were to retire. Vanguard Value has almost no manager risk at all because it is run by automated rules.
Vanguard Value has its own particular risk which we might call popularity risk. Research on the outperformance of value shows that over long periods this style of investing falls out of favour. While the fund is not concentrated in a few stocks it is concentrated in this style and the risk is that the style underperforms as other styles or investment fads come to the fore. What history shows, however, is that value has always come back into favour and that over long time periods it has consistently outperformed.
Global equity funds face a fundamental difficulty when trying to distribute their risk geographically. This problem is the huge size of the US equity market. It makes up about 40% of the global equity market so most funds reflect that by having a large US allocation. The iShares MSCI World ETF has a 60% US allocation with Japan a distant second (8.4%) followed by the UK (6.4%), France (3.6%), Canada (3.5%), Germany (3.4%), Switzerland (2.9%) and Australia (2.4%).
Fundsmith Global Equity and Vanguard Global Value Factor both have US allocations close to iShares MSCI World (Fundsmith 61.8%, Vanguard Value 56.1%). Lindsell train is interesting because thanks to Michael Lindsell's expertise in Asian markets it has a very large Japanese allocation of 22%. Fundsmith and Lindsell train both have a UK allocation that is much higher than MSCI World (Fundsmith 18%, Lindsell Train 27%).
These geographic allocations affect each fund's foreign exchange risk. For UK investors whose domestic currency is sterling any non-UK allocation will be partially driven by foreign exchange market movements. If sterling appreciates versus the US dollar any dollar denominated assets will lose their sterling value. Sterling depreciation versus the US dollar boosts the value of dollar-denominated assets.
Volatility is another way of looking at the risk of a fund. This is the annualised typical daily percentage price movement. The more a fund's price moves around the greater its volatility risk. All three funds have volatility comparable to owning the MSCI World index (13.4%). Fundsmith and Lindsell Train are a bit less volatile (12.4% and 12.5%) and Vanguard Global Value is a bit more volatile (15%).
Correlation tells us how closely two fund prices move in tandem with one another. If they:
- Always move in the same direction the correlation would be 100%
- Always move in opposite directions the correlation would be -100%
- Are unrelated the correlation would be 0%
If we look at correlation of these funds and the iShares MSCI World ETF it's interesting that Fundsmith and Lindsell Train have an 80% correlation with one another but a lower correlation to iShares MSCI World (57% for Fundsmith, 49% for Lindsell Train). Vanguard Value has a very high correlation to iShares MSCI World of 91%. The important message for investors is that it probably wouldn't make sense to own both Fundsmith and Lindsell Train or, alternatively, both Vanguard Value and iShares MSCI World. If you did own these pairs of funds they would bring no diversification benefits to your portfolio.
The fee you pay for Fundsmith and for Lindsell train are complicated by the fact that they have share classes. If you buy different share classes you are buying a slice of the same fund but you may be paying a different fee for the same thing. An additional layer of complexity is that different platforms offer different share classes and negotiate "special deals". This means that if you move platform you may end up losing your special discount and paying more for the same fund. Vanguard Value isn't charged in this way - you pay a very low fee of 0.22% on any platform.
The picture above shows the cost of Lindsell Train on a variety of platforms. The number in red is the ongoing charge for the fund on that platform and the number in blue is the cost of holding that fund on that platform. The total cost, which is the sum of the two, is in black. While Hargreaves Lansdown has negotiated a 0.2% reduction in the fee it is a relatively expensive platform so the total cost of buying and holding Lindsell Train Global equity adds up to 0.99%. Overall it is cheaper to buy the same fund, albeit a different share class, on either Barclays Smart Investor or AJ Bell because their platform fee is half as much as Hargreaves Lansdown.
Fundsmith Global Equity is the most expensive of the three funds with the platform fee determining the cheapest overall cost of buying and holding the fund. On AJ Bell, for example the cost of Fundsmith Global Equity is 1.15% versus 0.91% for Lindsell Train Global Equity and 0.42% for Vanguard Global Value. If you hold Vanguard Value on their own direct to consumer platform you would pay even less, just 0.15% platform fee, a total of 0.37%.
Although it doesn't sound much a difference of 0.5% to 0.8% in fees can compound dramatically over time. Over a decade Fundsmith would have to outperform Vanguard Value by 7% and over two decades by 15% in order to get better returns to overcome this fee difference of 0.7%. This is a huge hurdle that grows rapidly due to fee compounding.
Of course, nobody knows which fund will outperform in future. Ultimately this is a matter of where you put your faith. Do you put your faith in the promises of a fund manager who claims to be able to do what 95% of UK global equity fund managers cannot do, and beat an index? Or do you put your faith in historical patterns that you hope will reassert themselves?
Personally, I don't buy into the cult of personality that surrounds fund managers. History is littered with fund managers that made grand promises and seemed to achieve glittering success only to fall by the wayside to be rapidly forgotten and replaced with the next superstar. I put my faith in empirically proven strategies that can be bought cheaply and which aren't dependent on the timespan of one person's career.
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