Going into 2018, investors may pause for thought. Global stock markets have been going up for a long time, valuations look high and – from North Korea to Brexit – there are plenty of things to be worried about. In this environment, any option that promises to smooth out some of the peaks and troughs of the investment journey is worth investigating. (This article was written before the market declines of 5 February.)
Fund pairing involves investors splicing together two contrasting funds within the same asset class. The premise is that different fund managers will have different styles, which will affect their performance over and above the stocks they choose. By blending managers with different styles, when one fund is doing badly the other fund should compensate, giving a more even return over time. An example of this type of blend for UK equity income might be, say, a value-focused team such as Schroder Income’s Nick Kirrage and Kevin Murphy, set against a more structural growth manager such as Nick Train, manager of the Finsbury Growth & Income Trust.
This would have helped in 2017, when there were clear styles in favour, notably momentum and growth, and others out of favour – value and quality. However, the question is whether this approach leaves investors over-diversified: does it end up being an expensive way merely to achieve the market return? In this case, would investors have been better off focusing specifically on picking the right style for the current environment?
Chady Jouni, head of equities at Barclays Investment Solutions, points out that underlying style biases are important in a fund manager’s performance versus both their peers and the broader indices. He explains: ‘For example, a quality growth strategy significantly outperformed a value strategy over the past 10 years for equities in almost all regions, while the pre-financial crisis period was more favourable for value investing.’ Equally, a manager who favoured smaller companies would have had a distinct advantage in recent years.
Understanding the style biases
If investors don’t understand these style biases, it can leave them disappointed by a fund’s performance, even though that fund may have technically performed strongly versus its own style. Jouni says that the blending of managers can provide a solution by smoothing the relative return in the short term.
Equally, Jason Broomer, head of investment at Square Mile Research, points out that it is possible to take a good growth manager and a good value manager and blend them, without diversifying away all the ‘excitement’ of each fund and ending up with an expensive market tracker.
He adds: ‘Growth and value are not mutually exclusive. If you have growth companies trading at cheap valuations, they could appear in both styles. Likewise, parts of a value manager’s universe could be considered growth investments.’
Andrew Morgan, portfolio manager at Walker Crips, says blending works well in some areas. ‘We believe a “complementary pairs” approach can work to gain broad market cap exposure: active equity funds often focus on a particular segment of the market. In order to gain exposure to, say, North American equities, we frequently combine a large-cap fund with one that focuses on smaller companies. Unlike growth versus value, this isn’t the case of small-caps cancelling out the returns of large-caps or vice versa, as there is still substantial correlation between the two.’
Others use fund pairs more widely, believing it is difficult to time entry and exit from different styles. Jordan Sriharan, head of fund research at Thomas Miller Investments, says: ‘We are not trying to time the value/growth cycle, so we pick complementary sets of pairs…we want the best of breed in the value and growth spaces.’ He says this can be achieved using active and passive funds. ‘The FTSE 100, for example, can be cyclical, while active managers may be more [defensive and] income-driven.’
He also uses fund pairs in emerging markets, currently balancing the Hermes Emerging Market fund with the Somerset Emerging Market Dividend Growth fund. He says: ‘One is style-agnostic and the other has more of an income focus. In 2017, technology was a huge driver of returns. Hermes has a tilt to technology names, and saw fantastic performance in 2011. It rose 35 per cent; Somerset rose 21 per cent. ’
Getting the blend right
Similarly, within fixed income, he will blend managers who focus purely on credit selection in corporate bonds with those who aim to profit from ‘duration’ (changes in interest rate expectations).
However, blending needs to be done correctly. Morgan says that pairing can often be a proxy for a lack of conviction: ‘Investors can easily fall into the trap of over-diversification, whether that’s simply having too many holdings in a portfolio, or being exposed to too many investment styles.
‘Yes, combining styles can reduce damage when a particular style goes out of fashion. However, the obvious corollary is that it also can reduce – or even completely remove – the ability of a portfolio to outperform at all, with the outperformance of one style being cancelled out by the underperformance of another. Such over-diversification can leave a manager essentially tracking a market which, after fees are taken into account, can result in underperformance.’
In effect, if an investor insists on complete balance across the board – incorporating small cap, larger cap, value, growth and momentum – that would cover most of the market and they would probably end up near the market return.
There are also asset classes where this approach does not work. It probably isn’t worth holding two gilt managers, for example, while absolute return funds don’t tend to fall into neat complementary styles. In the US market, meanwhile, Sriharan has held a tracker for the last seven years; balancing this with a stock-picking ‘value’ option would simply have detracted from performance. However, he is now seeing signs that active funds may outperform once again and has taken exposure to the JPM Equity Income fund.
Some investors still prefer to try and time the best moment to go in and out of different styles. While this approach has its detractors, who say it is difficult to do successfully, some believe it is important to shift between styles as the market changes.
Gary Potter, co-manager of the BMO Global Asset Management Multi-Manager team, says: ‘On the one hand I applaud the idea of having, say, Nick Train and a value manager together, taking the best of the best to give better than market exposure. Certainly we do some of that. In the US, for example, we hold Edgewood, which is one of the best US growth managers, and we also have ConventumLyrical, which has more of a value style.
‘But what we’re trying to do is not just growth and value, or to get a little more than the index. The average value manager will have their share of tough times, and we have to buy at the right time rather than shying away from the decision. There will be times when it is right to reduce exposure to one style over another.’
But how to do this? Broomer admits it isn’t easy, but says it is about listening to the managers and the market. While most managers will always be positive on their own asset class, some are more honest and, as such, are worth listening to. It is also possible to be guided by past experience in the market: ‘For example, you know at the end of a bull market that certain factors will play out. Money sloshes around and assets aren’t priced correctly. You will tend to get a momentum surge and fundamental analysis will struggle in that environment.’
Jouni believes there are three key aspects to consider for a successful blend. First, investors need to carry out a thorough qualitative assessment of the underlying funds, to ensure their ability to add value relative to other similar funds. Morningstar has useful tools for comparison. He also believes the blend should be closely monitored, as correlations could increase over time and adjustments to the positions may be needed.
Fund pairing is not an easy route to smooth returns. Poorly constructed and monitored, pairs could easily prove an expensive way to track the index. However, used right, ‘best of breed’ managers with complementary styles can be a sensible start to portfolio construction.
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