The overlooked fund outperformers

Many now popular funds operated with relatively small sums of money for some time before eventually building up scale. SDL UK Buffettology (GB00BF0LDZ31), which has significantly outperformed its peer group over many years, might now account for more than £1bn in assets, but this has taken some time. The fund launched back in 2011 and had less than £100m in assets as recently as early 2017, according to FE Analytics. Several other funds have taken on large amounts of money almost abruptly after operating for years with lower levels of assets.

Many of these funds can continue to do well even once scale develops. The Buffettology fund returned 0.37 per cent in 2018, a year when the average fund in its Investment Association (IA) UK All Companies peer group lost more than 11 per cent, despite its growing size.

However, the story of the overlooked outperformer is not unusual. The dynamics of the investment industry mean that many outstanding funds will continue to go a long time without taking on many assets, if they do at all.

Many professional investors, for example, tend to look for funds with a track record of three years or more, and assets of at least £100m, to invest in. This means that funds often fail to get widespread attention until they have already reached this size or gone well beyond it. For private investors with the confidence to back a lesser-known name this can create an advantage, because overlooked outperforming funds can give your portfolio an edge others might lack.

Small is beautiful

As we noted at the end of last month, established funds can grow to such scale that the weight of money under their control actually hinders performance. But even leaving aside this argument, there are many good reasons to consider backing those funds that remain under the radar for most investors.

For one, fund managers with less established funds are often hungry for success. This means that they tend to be entirely focused on delivering the best performance possible, without any of the distractions that may come later on in their career.

“Managers are often fully engaged and keen to deliver returns to build their reputation – and assets,” says Robert Blinkhorn, head of investment management at Wise Investments.

These funds are also more nimble than their larger peers, in many respects. Because they have limited assets they can often easily operate across their investment universe without running into any liquidity problems – unlike managers of large funds, who need to invest big sums of money to establish meaningful portfolio positions, and can risk shifting share prices by doing this alone. This can sometimes mean that, as in the case of Buffettology, lesser-known funds can back smaller, higher-growth companies and extract what Mr Blinkhorn refers to as “liquidity premia”.

Lesser-known funds with strong returns can also sometimes attribute these to a distinctive investment approach, meaning they may well add a level of diversification to your portfolio. On top of that, they are less vulnerable to the mass outflows that can plague a star manager falling from grace.

For some professional investors with the ability to back smaller funds, the strategy has worked out well. Shaun McDade, director at investment company MitonOptimal, notes that the company's history of investing in some funds with “modest" assets under management has been positive so far.

“GVQ UK Focus (IE0033377494) and Waverton European Capital Growth (IE00BF5KTH98) spring immediately to mind.” he says. “Both have been core positions and successful performers for us over many years.”

However, anyone backing smaller funds should, if possible, get a sense of whether the team behind the fund has adequate resources to fuel any future successes. This could include looking at the size of the investment team and what other resources the manager has at their disposal. As always, the fund’s process and performance should also stand up to scrutiny.

“While there’s a comfort factor in going for large shops, providing we can satisfy ourselves that a manager is sufficiently well resourced from an operational perspective and meet all of our usual qualitative due diligence considerations, we’re happy to back smaller funds when the performance numbers warrant it,” says Mr McDade.

No free lunch

Backing smaller funds is not without its own pitfalls, and the most obvious of these relate to costs. Challenges including a growing regulatory burden have seen the costs of running a fund rise significantly over the years – and many fund providers need to manage a good chunk of assets before economies of scale arise and running a fund works out commercially. So funds under £100m in size, and sometimes even bigger, frequently run the risk of being closed or merged into another product. This can be both inconvenient and potentially costly for investors.

“Small funds are often uneconomical and run the risk of being closed,” notes Mr Blinkhorn. “If they do close, unit holders could end up paying closure costs.”

If smaller funds are run by less established asset managers, similar risks can apply to the business itself. With the costs of business on the up, smaller fund firms face the prospect of failing or being acquired by bigger rivals.

Even in a less extreme scenario, if a smaller fund is not cheap to run this can be reflected in the costs borne by investors. It is not uncommon for a fund with fewer assets to carry ongoing charges of 1 per cent, if not higher.

However, there is a silver lining here: those funds that do succeed and become much larger can end up passing economies of scale to investors in the form of fee reductions. The Buffettology fund is just one example where fees have come down as the product itself has grown in size.

These funds, by their nature, have also attracted little attention so far and can be difficult for private investors to find. Due diligence may equally be more difficult to carry out on these products than bigger names. But for those investors willing to take a chance on less established funds, we have identified some possible candidates in the table below.

As part of our analysis we have looked for funds with the best annualised three-year information ratio versus their benchmark. The information ratio has been chosen because it is widely deemed a more accurate reflection of a fund manager’s skill than simple past performance figures. This is because it is a risk-adjusted measure, taking into account the amount of risk a manager has taken in order to achieve their outperformance. We have also included funds' returns versus their benchmark, to provide further context.

Risk-adjusted outperformance can vary between different regions and asset classes, with UK, European and global funds currently standing out. The numbers come in lower within the bond universe, probably because the returns on offer here tend to be lower in general. We also considered investment trusts, but a scarcity of trusts with less than £100m means the examples here are all open-ended funds.

Any of the funds listed below could stand out in a portfolio, but a good information ratio is not a good enough reason to invest on its own. It is also worth seeing how such a fund might complement other portfolio holdings, whether the approach on offer chimes with your own view as an investor, and what costs and risks you might bear in supporting it.

Less established funds to consider

Source: FE Analytics as of 23 September 2019. *Platforms.

The picks

One longstanding outperformer with a differentiated approach is Cavendish Aim (GB00B0JX3Z52). This fund has consistently outpaced many other UK equity growth funds – in part because it fishes in Aim, where both the risks and rewards tend to be higher than with larger companies. As such, this is a relatively high-octane approach. But as the table shows, the fund, which looks to offer a diversified portfolio of Aim stocks, has strongly outperformed the Aim All-Share index over the past decade. Even amid the volatility of 2018, the fund lost less than the average IA UK Smaller Companies member. Another UK growth fund with a more conventional approach but impressive returns in its own right is Slater Recovery (GB0031554248).

Elsewhere, ASI European Smaller Companies (GB00B0XWN580) has performed well over what have been difficult years for its underlying market. The fund has a notable level of exposure to sectors associated with high growth, including a 21.2 per cent allocation to healthcare and 19 per cent in information technology at the end of August.

Investors wanting to back a lesser-known outperformer in a market that has proved volatile may also be tempted to use Vanguard Global Emerging Markets (GB00BZ82ZY13). Unlike many of Vanguard's most popular products in the UK, this is an active fund, whose management is outsourced to Baillie Gifford, Oaktree Capital Management and Pzena Investment Management. The fund is highly diversified, with 160 holdings at the end of August. This may appeal to investors, given the higher-risk nature of emerging markets.

For investors looking for outperformance in a region they feel more comfortable with, Artemis US Equity (GB00BMMV4S07) has fared well in a market that continues to drive global returns and has been notoriously difficult for active managers to beat. The fund might lack substantial assets, but it is managed by Cormac Weldon, an experienced US stockpicker who joined Artemis from Columbia Threadneedle in 2014.

When it comes to corporate bond exposure, BMO Multi-Sector Higher Income Bond (GB00B8191314) has stood out versus its IA Sterling High Yield peer group. As its name suggests the fund has a focus on income, with a distribution yield of 4.2 per cent at the end of August. However, investors should be aware that its focus on higher-yielding debt lends this fund an element of risk, and it should be viewed in that light rather than as a defensive holding for difficult times.