Bill Jamieson: Is investing success due to luck or judgment?
This article contains affiliate links. We may earn a small commission on items purchased through this article, but that does not affect our editorial judgement.
Most of it, many would say. It is rare for funds and trusts to stay in the top slot for long. And success can come down to little more than happenstance: being in the right place at the right time.
The careers of fund managers are built round a belief that markets are rational; that company performance can be quantified and reasonably predicted.
• READ MORE: Markets and economy news
Advertisement
Hide AdAdvertisement
Hide AdBut how much of their fund performance can be attributed to their skills rather than, well, pure luck? Last week brought an analysis of this question. Step forward, Andrew Summers, of wealth managers Investec, with the formidable title of “head of collectives” – overseeing the bewildering array of hundreds of investment funds and trusts competing for savers’ money.
“If we cannot distinguish luck from skill”, he writes, “we cannot hope to identify in advance fund managers who will outperform. And if we cannot distinguish simple outperforming attributes from skill then we may be paying an active manager a fee for outperformance we can find more cheaply elsewhere.”
The area he singles out for attention is the UK mid-cap sector. The investment website Morningstar defines large-cap companies as those that account for the top 70 per cent of the capitalisation of a domestic stock market. Mid-cap stocks represent the next 20 per cent and small-cap stocks make up the remainder.
In the UK, large caps are generally considered to be those that are listed in the FTSE 100 index. Mid-cap companies are generally considered to be those listed on the FTSE 250, which ranges from a market cap of approximately £4 billion down to £500 million. The FTSE Small Cap index includes stocks worth as little as £150m.
About 80 per cent of the value of the FTSE All Share is in the biggest 100 companies, the FTSE 100. Some 15 per cent of the value is in the next 250 companies and just about 5 per cent in the remaining, smaller still companies.
The vast majority of funds in the UK equity sector, notes Mr Summers, are heavily overweight middle-sized (FTSE 250) companies compared with their FTSE All Share benchmark. Over time, he adds, this typically leads to strong out-performance as these mid-cap companies typically outperform large cap companies.
But is having an overweight to mid-caps really investment “skill”? Mid-caps have outperformed large caps for two years out of every three since 1955.
Advertisement
Hide AdAdvertisement
Hide Ad“Thus”, Mr Summers writes, “a fund manager with a large overweight to mid-caps will, all other things being equal, outperform a manager without over a market cycle, without any difference in manager skill.”
One oft-cited drawback is that this area is only thinly researched by market analysts because of limited marketability. And large investment institutions cannot obtain a sizeable holding without shifting the price against them. But going where the big beasts fear to tread could, he says, prove an advantage.
Price anomalies in the FTSE 100 can soon be pounced upon and advantage quickly lost. “The vast majority of company research”, he argues, “is focused on the larger companies, leaving an opportunity for more mispricing and stock selection skills in the mid-cap space.”
But funds and trusts concentrating solely on investment in mid-caps do not consistently hog the top performance tables. Indeed, in the wake of last June’s EU referendum vote, many mid-cap equities suffered as investors fled to the larger, less UK-dependent behemoths of the FTSE 100.
“We tend”, says Mr Summers, “to give more credit to managers who vary the market cap mix of their funds rather than keeping it static, the latter perhaps being a sign of a manager looking to “ride” mid-caps’ long-term outperformance. After all, over time there have been long periods where large caps have been cheaper than mid-caps.
“There are times when the UK’s large cap companies offer better prospects in aggregate than its mid-caps. A poorly performing UK economy with further sterling weakness might well help the UK’s larger companies with their more international revenue streams. A good fund manager may know to be overweight mid-caps over the cycle, but not overweight mid-caps throughout the cycle.”
So look for a fund manager’s open-mindedness, agility – and willingness – to move across the market when circumstances merit. And that takes judgment.