Funds inevitably have their up and downs in performance. When a fund has gone through a particularly poor spell, does this represent a buying opportunity for investors in the expectation it will bounce back to form?

Likewise for existing investors, should they stick or twist? Fortunately, there are lots of studies from the institutional fund management world which provide answers to that question and we round off this article by looking at three underperforming funds which look ripe for a recovery.

Typically, institutional fund managers are walking on thin ice after three years of underperforming their benchmark and peer group.

A 2006 study by Amit Goyal and Sunil Wahal covering institutional hiring and firing decisions by around 3,500 pension plan sponsors over a 10-year period from 1994 to 2003 showed that the subsequent return of the fired managers was frequently positive and better than the new managers hired.

There have been several studies over the last 20 years which come to the same conclusion. This should not come as too much of a surprise for readers of our recent article on the seven deadly sins of investing. 

In it we discussed how professional investors are often more susceptible to being tripped-up by behavioural biases than the ordinary investor.

These challenges also apply to consultants who hire and fire fund managers. Chasing fund performance (buying the winners and selling the losers) and overconfidence in picking the best managers are two factors which go a long way to explaining the results of the studies.

WHY IS THREE YEARS A GOOD THRESHOLD?

It is unrealistic to expect a fund manager to outperform an index or peer group all the time. Holding different stocks to peers or the benchmark inevitably means performance will diverge, both positively and sometimes negatively.

There is nothing special about a three-year period which magically indicates loss of fund manager’s mojo, which begs the question, what is a reasonable period of underperformance?

In 1984, Warren Buffett wrote an article for the Columbia Business School magazine Hermes titled ‘The Superinvestors of Graham-and-Doddsville’. In it he presented and discussed the investment performance of some of his peers who had been taught by the legendary Benjamín Graham.

Over periods ranging from 13 years to 28 years, the group outperformed the market by between 8% and 17% per year.

What is striking about these ‘superinvestors’ is that they all suffered significant underperformance at some point along the way to building spectacular long-term track records.

On average, they underperformed around a third of the time they managed money (the range is 7.1% to 42%). The worst three-year underperformance (peak to tough percentage loss) saw one manager fall almost 50% behind the benchmark.

The lesson from these results was neatly summed up by Eugene Shahan, who graduated from the Columbia Business School, and wrote an article on Buffett’s findings.

He said: ‘It may be another of life’s ironies that investors principally concerned with short-term performance may very well achieve it, but at the expense of long-term results.’

EXAMPLES OF FUNDS WHICH HAVE RECOVERED FROM A BOUT OF POOR PERFORMANCE

We have identified some names which managed to follow a poor three years up to October 2021 by turning things around in the subsequent three years.

Value-focused investment trust Temple Bar (TMPL), steered by experienced investor Ian Lance, struggled to make any progress between 2018 and 2021 but has returned to form to become a top-quartile performer since then.

Another fund which has demonstrated bouncebackability is Jupiter UK Income (B5VXKR9). Although the imminent departure of well-regarded manager Ben Whitmore to set up his own boutique investment fund means this portfolio changed hands in April to be steered Chris Morrison and Adrian Godsen.

OTHER FACTORS TO LOOK FOR

Factors other than performance can be helpful in ascertaining whether to stick with or invest in a fund. Most successful funds have a well-defined philosophy and investment process which is consistently applied through good times and bad.

Therefore, one area to probe is how consistently a manager applies his or her chosen investment process. If a manager starts to waver from the principles which produced past returns, it could be a sign of style drift and indicate future underperformance.

A good example is Neil Woodford. After setting up his own shop, he famously moved away from what had made him so successful at Invesco Perpetual. At Invesco he had been buying mainly large cap stocks whose income potential had been undervalued by the market but he moved into unquoted early-stage businesses with disastrous consequences for investors.

Any noticeable change in the way the fund is managed such as the number of stocks held in the portfolio, or how often the stocks are changed, are potential red flags unless the changes are clearly justified by the investment manager.

It is worth noting that style drift is different from making tweaks to the investment process to improve performance.

For example, Fundsmith founder Terry Smith told Shares that after reviewing the team’s selling discipline, they believed it could be improved.

Shares which Smith and head of investment research Julian Robins believe should be sold but are benefiting from an identifiable tailwind from themes such as AI (artificial intelligence) should be given more time before pushing the sell button.

Change of personnel is another sign that a fund might be undergoing a fundamental shift which could impact future performance.

In order to identify funds and trusts which have endured a recent bout of underperformance but where we still believe in the strategy and long-term potential we ran a screen of the market. We looked for products which had chalked up fourth quartile performance over the last three years.

Read on to discover the three names from the resulting list of more than 200 which we now think could be ready for lift-off.

SLATER GROWTH FUND (B7T0G90)

Price: 688.84p

Fund size: £684.5 million

Mark Slater and his team have delivered an excellent long term track record managing the Slater Growth Fund (B7T0G90) which has a cumulative return since inception in 2012 of 198.2%, compared with the 111.9% return of the IA (Investment Association) UK All Companies index.

Over the last three years the fund has underperformed its peer group by a wide margin, down 23% compared with a 9% gain for the AI UK All Companies index.

Shares believes the pedigree of the manager suggests the fund has good bounce back potential.

Slater applies a proven investment process which starts with a screening of the UK universe across several criteria, including the PEG (price earnings ratio to growth rate) popularised by his father Jim Slater, and sustainable earnings growth.

The team then conducts thorough in-house research and if they still like the business they meet company management. An assessment of the risks and opportunities is then made before a final decision is made.

Slater puts recent underperformance down to a big de-rating in the small and mid-cap parts of the UK market plus rising interest rates, accentuated by fund outflows. Slater believes this section of the market is so beaten up it is now ‘pretty resilient to bad news’.

The manager points out that historically when small caps as a group trade on under 10 times earnings they have subsequently rallied around 60% over the following two years. This part of the market now trades on a PE (price to earnings) ratio under nine times, says Slater.

Top holdings include outsourcing company Serco (SRP) which Slater says is a much better business than it was a few years ago, something which is yet to be fully appreciated by the market. [MG]

MONTANARO UK SMALLER COMPANIES (MTU)

Price: 105p

Market cap : £177 million

Discount to NAV: 11.6%

Montanaro Asset Management was set up in 1991 and has 16 analysts and fund managers dedicated to picking smaller stocks, which could just make them the biggest small-cap team in the UK.

Founder and chief executive Charles Montanaro chose the closed-end investment trust structure for his high-quality growth strategy as it meant not having to buy and sell stocks depending on inflows and outflows.

The team looks for simple businesses in distinct niches, which makes them less vulnerable to the vagaries of the economic cycle, and they have to be profitable – there are no early-stage or venture-capital style investments in the portfolio, companies have to be money-making before they even get on the radar.

It is well-known that small-caps outperform large-caps over the long term – with some of them eventually becoming large-caps in the process – and the dearth of publicly-available research means there are plenty of opportunities for the Montanaro team to find undiscovered gems.

Unusually, especially for a small-cap growth strategy, the trust pays a regular dividend of 1% of its NAV (net asset value) every quarter, equivalent to a yield of 4% per year.

The fund generated almost a 950% return from its inception in 1995 to September 2021, but in the three years since it has struggled as small-cap value has outperformed growth aided by the sharp rise in interest rates.

The fund was back on track in the first half of 2024, outperforming the index as it became apparent rates were set to fall, but the sluggish pace of cuts has held it back in the third quarter despite excellent results from its portfolio companies.

The current top 10 holdings include FTSE 250 stars 4Imprint (FOUR), Big Yellow (BYG), Bytes Technology (BYIT), Clarkson (CKN), DiscoverIE (DSCV), Games Workshop (GAW) and XPS Pensions (XPS), and we firmly believe the trust is set for a return to form in the years ahead. [IC]

RIT CAPITAL PARTNERS (RCP)            

Price: £18.32

Market cap: £2.65 billion

Discount to NAV: 29.5%

It’s been a challenging three years and a lost decade for capital preservation and growth fund RIT Capital Partners (RCP), whose stated purpose is ‘to grow your wealth meaningfully over time, through a diversified and resilient global portfolio’. FE fund info data shows the £2.65 billion cap has produced a negative 33% three-year return, while performance lags the MSCI AC World (50% £) benchmark over ten years, which is reflected in a near-30% share price discount to NAV (net asset value).

A difficult period for NAV performance in 2022, concerns over the valuations of unquoted investments and a headwind from cost disclosures drove a sharp de-rating and left investors questioning what role RIT Capital played in their portfolios. And as Deutsche Numis explains, ‘many were left without the information to answer these questions and we believe this has contributed to the selling and lack of demand’, but the broker believes RIT Capital’s NAV has ‘potential to deliver an attractive return profile in future and the discount offers a value opportunity’.

More recently, manager Maggie Fanari has been articulating her plan to revive the trust’s fortunes to investors who’ve seen an uptick in portfolio performance, while buybacks continue apace and falling interest rates should offer a tailwind.

As of 30 September 2024, NAV was £26.19 per share, up 1.5% from the previous month, and meaning the fund had generated a positive NAV total return of 8.8% year-to-date. Recent performance has been driven largely by the quoted equities book, boosted by the rally in Chinese holdings rallied, with private investments and uncorrelated strategies chipping in with positive contributions.

It is also worth noting that many of RIT Capital Partners’ largest direct investments are profitable companies with growing earnings, while its private fund portfolio includes some of the globe’s best performing funds, which are well positioned when the IPO (initial public offering) window opens. [JC]   

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