Last year was a good year for global markets, but not so good for the relative performance of active funds. Asset manager Janus Henderson was also fined £1.9m for overcharging investors in active funds that did not perform very differently to passive funds – so-called ‘closet trackers’. Passive index-tracking funds domiciled in the UK, meanwhile, attracted net inflows of £19bn, while active funds saw outflows of £36bn – their highest level on record, according to data provider Morningstar.
But around 40 per cent of active funds domiciled in the UK outperformed their benchmarks in the 2019 calendar year. And over longer periods, certain active funds have outperformed relevant benchmarks by quite some margin. For example, over five years to the end of 2019, Fundsmith Equity (GB00B41YBW71) made a cumulative total return of 133 per cent, against 79 per cent for MSCI World index and the Investment Association Global fund sector average of 66 per cent.
Funds operate in a competitive and overcrowded market, so not surprisingly their managers are continually trying to find ways to set themselves apart from their peers.
Shift from broker research
Fund managers have not been able to rely on broker research as much as they used to following the introduction of the Markets in Financial Instruments Directive (Mifid) II in January 2018. These rules require funds to disclose how much they specifically spend on research, whereas previously brokers supplied research as part of a package for dealing services. As funds now have to disclose what they pay for research, their managers are more conscious of the value it provides and many have opted to pay for it themselves rather than pass the cost on to investors in the funds they run.
And while some broker research is very valuable, there are instances when it is not that helpful. A study of analyst ratings on FTSE 350 shares by broker AJ Bell found that last year sell ratings delivered a positive return of 28.9 per cent while their buy ratings delivered a positive return of 23.2 per cent. The analysts' ratings for FTSE 100 shares alone did slightly better, with buy ratings returning 23.2 per cent, compared with 18.4 per cent for sell ratings.
"We have back-tested the performance of analyst ratings since 2015 and the conclusion from 2019’s data is the same as in prior years – that the value in analyst research lies in their commentary and analysis [but] the ratings themselves need to be treated with a huge dollop of caution," says Russ Mould, investment director at AJ Bell.
Patrick Thomas, investment director at Canaccord Genuity Wealth Management, says that fund managers are “much more attractive” when they conduct their own research, and have built their own systems and processes. For example, the managers of Fundsmith Equity, who include high profile investor Terry Smith, do all their research in house. This fund typically holds between 20 and 30 large global companies, mainly listed in the US and UK.
However, Katie Potts, manager of Herald Investment Trust (HRI), says broker research is particularly helpful for drawing your attention to smaller companies, which this trust focuses on. Herald Investment Management does not pass the costs of the broker research on to Herald Investment Trust's shareholders. Ms Potts adds that she would worry if companies the trust holds did not invest in research and development, so she applies the same principle to her own investment strategy. “We wouldn’t want to miss an opportunity just because we didn’t pay for research,” she explains.
Academic advantage
Some asset managers such as Baillie Gifford and Pictet are turning to universities and scientists for research. They say that this helps them make better decisions about the long-term prospects for companies. James Budden, director at Baillie Gifford, says that the company spends significantly more on funding academic projects than on paying for research by investment banks. “Building relationships with people who are at the top of their field gives us the ability to explore ideas in areas such as artificial intelligence and healthcare,” he explains.
Mr Budden adds that markets are driven by small groups of companies that are big winners, and if you want to be successful you need to find these. “We try to be different – our processes are about the future, not the past," he says.
Baillie Gifford has links with universities including The University of Edinburgh, which it is helping to fund a 10-year research programme into data and artificial intelligence (AI) ethics. Baillie Gifford is also funding research into computational biology – diagnosing diseases by gathering data – at Tsinghua University in China.
James Anderson, partner at Baillie Gifford and manager of Scottish Mortgage Investment Trust (SMT), says: “Generally I prefer our research to appear irrelevant. The further it is from being a direct debate about the merits of a company as an investment, the happier I tend to be.”
Baillie Gifford also sponsors academics such as Hendrik Bessembinder, professor at Arizona State University, who is conducting research on historic stock market returns in the US. Prof Bessembinder has calculated that the entire gain of the US stock market since 1926 is attributable to the best performing 4 per cent of listed companies and is trying to identify the common factors of these companies.
Asset managers that run funds along the lines of themes are also gleaning insights from academics who conduct deep analysis within a specific field. Pictet has appointed an advisory board for each of its thematic strategies composed of academics, entrepreneurs, business leaders and scientists. Steve Freedman, senior product specialist, thematic equities at Pictet Asset Management, says that advisory boards help investment managers understand how a theme will develop, for example, by identifying the mega-trends driving them and possible future industry trends, and looking at how government policies and new technologies might affect them. "Advisory boards are not involved in stock selection, but they do help us shape and evolve a theme over the longer term," adds Mr Freedman.
For example, professor Asit Biswas, president of Third World Center for Water Management, a think-tank that promotes efficient water management, is on Pictet's water advisory board. And Vaclav Smil, a professor in the department of environment and geography at the University of Manitoba in Canada, advises Pictet on its clean energy strategy.
“How you add value as an active manager over the next decade will probably [rely on] being an expert on a particular theme,” adds Mr Thomas.
Artificial intelligence
Some hedge fund managers have used machine learning, a type of artificial intelligence (AI), in their investment processes for years. But although many large managers of long-only (non-hedge) funds are considering using AI as part of their investment research, according to Ryan Hughes, head of active portfolios at AJ Bell, he doesn't know of any who regularly use it as part of their long-only investment processes.
And a study by the CFA Institute, a global association of investment professionals, published in September last year found that only 10 per cent of fund managers have used AI techniques to improve their investment processes, while 95 per cent continue to rely on Excel spreadsheets rather than sophisticated coding software that supports machine learning.
One reason for this may be because, to date, there is little evidence that AI has improved the performance of active funds.
However, asset manager BlackRock has built machine learning powered tools to cleanse and analyse volumes of data from sources such as analyst reports, annual reports and economic forecasts. It also uses these tools to analyse newer data such as GPS satellite imagery, to see where people are going, and internet searches and tweets to see what people are researching and talking about.
BlackRock also uses natural language processing (NLP), a field of AI that gives the machines the ability to read, understand and derive meaning from human languages. Fund managers might use it to interpret sentiment in documents such as historical conference call transcripts and sell-side analyst reports to learn what language matters when forecasting changes in sentiment or longer-term fundamental trends. David Wright, head of product strategy for systematic active equity in Europe, the Middle East and Africa at BlackRock, says that fund managers who use artificial intelligence might examine large datasets to identify relationships, or determine sentiment by using NLP to scan news publications, social media or annual reports.
Mr Wright says BlackRock has also built a tool powered by machine learning that combines different data sources into a diversified stock scoring model. The technology tries to identify the combinations of insights that are likely to matter the most when trying to determine the future performance of a stock.
JPMorgan Asset Management, meanwhile, launched its first fund which selects stocks via machine learning – JPM Thematics Genetic Therapies (LU2053353822) – in November last year. The fund's managers use NLP to screen more than 10,000 stocks globally, analysing information such as news articles, research notes and regulatory filings, to identify which stocks are likely to provide the best exposure to genetic therapies.
ESG considerations
The rise in demand both from regulators and investors for fund managers to consider environmental, social and governance (ESG) factors in their investment processes is forcing them to look beyond financial drivers. “The sophistication of ESG has changed dramatically,” says Vanessa Bingle, senior manager at consultancy Alpha FMC. While ESG was optional, even as recently as two years ago, now many asset managers consider ESG factors to a certain extent in their research processes.
Fund managers also appear to be more active owners, in so far as there has been an increase in the numbers of votes against resolutions at companies' annual general meetings, according to ShareAction, a charity trying to reform how large investors make decisions. This is partly because as institutional investors have grown, so has their responsibility to hold the companies they own to account.
“There has been a fundamental shift in what is expected from active fund managers,” adds Mr Thomas. “Asset managers have gone from focusing on stockpicking, to more of a focus on long-term ownership and what a company is doing.”
