Sinking feeling

Fund managers have struggled to keep their head above water over the past five years as most British retail funds failed to outperform their benchmarks and savings accounts. Nick Rice examines the impact of volatile markets and short-termism and summarises the lessons that managers have learned.

In late 2006, HSBC revealed losses on subprime investments in America that marked the beginning of the financial crisis. Five years on, the majority of British open-ended retail funds remain underwater compared with long-term savings accounts and the standard performance targets for their sectors.

Until the choppy markets of the summer and early autumn, the nation’s portfolios had resurfaced from the woes of the previous four-and-a-half years, only to be drowned over the past six months amid concerns over government finances. According to an investigation by Fund Strategy of data from FE Trustnet, just 18% of onshore retail vehicles, or 254 out of 1,425, outperformed both their targets and cash over the five years to October 25. The conclusion is stark: British retail funds either need to pray for more clement markets, or they need to be better designed to cope with the turbulence.

Rob Burdett, the co-head of multi-manager at Thames River Capital, says investors may have been blindsided by the volume of market falls over the past five years and by the extent to which their investments might underperform cash.

“We saw a piece about investors’ expectations [which asked] how often people should expect drawdowns of 20% or more over rolling five-year periods. The right answer is 60% of the time, but people would expect [them] 15-20% of the time,” he says.

Both Burdett and several other fund buyers, such as Ryan Hughes, a portfolio manager at Skandia, argue British fund managers should focus more on trying to outperform by protecting investors’ capital against market falls and thereby keeping up more consistently with cash equivalents. (Cover story continues below)

Investors’ targets

For savers, the point in selecting a fund or a range of funds is simple. The default route for savers’ money is a long-term cash account from a bank or a building society. If a saver chooses to lock up money for a short minimum period, the account pays a competitive rate of interest with minimal or no risk to the investor’s capital. (For the purposes of its investigation, Fund Strategy took the 12-month London Interbank bid or deposit rate (Libid) in sterling as a proxy. The rate returned 17.5% over the five-year period.) However, a saver who is prepared to lock up money for longer – typically at least five years – and take more risk can use a fund to target higher long-term returns. “Over five years, investors should judge investments against cash,” Burdett says.

The fact that only 18% of funds have outperformed cash and their benchmark indices – again, rather than their sectors – is not, in itself, a critical problem for savers. Savers can outperform cash using a mixture of funds that, individually, have underperformed their benchmark indices – as long as, overall, they outpace cash by a significant margin. If they select a mix of funds investing in different types of assets, with a variety of returns over the period in question, they have a good chance of outperforming a savings account.

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To achieve this aim, most savers are recommended to diversify their port­folio. If they are younger, and can save over a long time horizon, they are typically told to have a broad exposure to stocks, in a similar manner to funds in the IMA’s Active Managed sector. If they are middle-aged, they are instructed to have a more balanced mixture of equities and bonds. If they are close to, or in retirement, that portfolio becomes more cautious.

”Over five years, investors should judge investments against cash”

For British savers, however, this theory has a lethal flaw: it has not worked in practice. According to the FE Trustnet data, only 20% of funds in the IMA’s Cautious Managed sector, 21% in Balanced Managed and 17% in Active Managed have outperformed Libid over five years. The statistics are particularly concerning in the case of Cautious Managed, as the funds in question are typically run to a cautious cash-plus target, limiting short-term losses. Furthermore, British savers are unlikely to tolerate keeping money in underperforming actively managed funds on the way to outperforming longer term. They are more likely to put money in low-cost tracker funds that follow the benchmark index, which by definition will underperform it after fees are deducted.


The task of picking actively managed funds, then, remains as difficult as ever. One approach is to see which sectors have outperformed and treat them as more fertile territory for active managers. Predictably, several smaller sectors have outperformed, but these are not necessarily statistically representative peer groups. All of the funds in the Asia Pacific including Japan and North American Smaller Companies sectors and half in the Technology and Telecommunications sector outperformed their typical benchmark indices and 12-month sterling Libid over five years to October 25. However, these peer groups house four, six and six funds with five year records respectively. The other sectors with fewer than 10 funds that have done better than average are China/Greater China, European Smaller Companies and Europe including UK, with 33%, 25% and 22% of the sector outperforming.

According to Fund Strategy’s definition, only four small sectors with long-lived funds have a lower proportion of outperforming funds than average: Japanese Smaller Companies, Protected, UK Index-Linked Gilt and Unclassified.

”Managers in smaller companies are a different breed [in that] they bear little reference to an index”

Amid the larger, more statistically representative sectors, it has predictably proved tougher to beat Fund Strategy’s targets. About 38% of funds in the Global Bonds peer group outperformed, followed by 35% in North America, 29% in Asia excluding Japan, 29% in Specialist, 29% in UK Smalle r Companies, 22% in Global Emerging Markets, 21% in Balanced Managed and Global and 20% in Cautious Managed. These are outnumbered, however, by the 13 sectors with 10 funds or more where fewer than 18% of funds outperformed the targets. Even in the case of Global Bonds, the most successful sector, 38% of funds still give you a less than a 50/50 chance of selecting an outperforming vehicle.

However, most of the funds in the top five larger sectors did not outperform purely by virtue of outpacing a benchmark that beat long-term cash. In the case of the North America sector, the S&P 500 stockmarket index underperformed Libid, as did the Hoare Govett index in the case of UK Smaller Companies. The Specialist sector as a whole also underperformed the Libid target, although the funds in the sector can only be benchmarked against a large variety of different indices. The MSCI AC Pacific ex Japan index outperformed comfortably, as did most of the standard benchmarks in the Global Bonds sector. By contrast, the serial underperformers included the three major sterling fixed income sectors, the two Japanese equity sectors and Property. The latter three in particular have suffered a series of financial shocks in the last five years.

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Of the sectors, Burdett says that UK Smaller Companies is one of the most explicable outperformers, although its standard benchmark index has not beaten long-term cash. Its target investments tend to be under-researched and inefficiently priced, Burdett says, meaning it is easier for managers to concentrate their portfolios in a series of disproportionate bargains.

“Managers in smaller companies are a different breed [in that] they bear little reference to an index. The index is quite an unusual beast,” he says. By contrast, Burdett says, North America is “one of the hardest sectors to find managers” as its typical S&P 500 benchmark is so efficiently priced. However, Burdett observes American managers are often given the freedom to concentrate consistently on set styles of investing, such as growth or value, which tend to be better understood in the American market. Over the longer term, he says, “it can mean their focus gives good long-term returns”.

Patrick Armstrong, a managing partner at Armstrong Investment Managers, observes that equity or global bond funds with a North American bias may also have outperformed by virtue of the movement of dollars against sterling.

”Part of the problem as time has progressed is that people are getting more and more short-termist”

According to FE Trustnet, the dollar rose 17.6% against sterling in the five years to October 25. Any large cash weightings in dollars would on average have gained against sterling over the period. In addition, any global bond managers who held more than their benchmarks in dollar-based assets, which constitute the majority of the benchmark, would have received a straightforward, significant boost to performance. By contrast, Armstrong says that sterling fixed income managers typically adhere less to their benchmarks, which tend to be less well known by investors than their peers in the equity market. In the case of fixed income, he says the primary reason is that, for most managers’ tastes, sterling fixed income benchmarks are too concentrated in financials and riskier instruments, which in many cases would have outperformed over the period.

Unfortunately for Burdett and Armstrong’s peers, multi-manager funds also failed to outperform Fund Strategy’s criteria in large numbers. Of the larger players, the most consistent performers were funds of funds from Cazenove, Jupiter and Threadneedle, which were the only groups where at least half or all of the eligible multi-manager funds outperformed. Several multi-manager funds investing in a single asset class have closed in recent years after the managers decided it was too difficult for them to outperform. As Hughes has observed previously, Skandia is a case in point. Multi-managers have found it easier to add value in multi-asset sectors – but the three main multi-asset sectors, the Managed peer groups, have found it difficult to outperform.


What was true for fund sectors remained true for fund management companies as a whole. Of the biggest groups, Threadneedle had the largest number of funds that passed the criteria, with 19. BNY Mellon was second with 12, comprising its divisions Newton and Insight on 10 and two respectively. M&G was third with 12, followed by BlackRock, Henderson and Jupiter with eight, Aberdeen and Investec with seven and Axa, Baillie Gifford, First State, Neptune and Ruffer with six. Of the remaining larger groups, Scottish Widows as a whole had seven, factoring in funds at Scottish Widows Investment Partnership, Fidelity had five, Invesco Perpetual and Schroders four, Ignis two and Legal & General one. In terms of percentages, however, the outcomes with the larger groups were similar to the sectors.

Of the groups with 10 eligible funds or more, the only groups that gave investors more than a 50/50 chance were First State, with 60% of its funds beating the criteria, and Neptune, with 55%. However, the groups are smaller, with only 10 and 11 eligible funds in total, and, in First State’s case, several relatively similar products.

Among the bigger players, they were followed by Baillie Gifford with 38%, Threadneedle with 37%, Newton with 34%, Investec with 33%, Jupiter with 29%, M&G with 28%, BlackRock with 26% and Aberdeen with 20%. As with sectors, fund groups with eligible ranges in the single digits achieved much larger percentages – 100% in the case of Ruffer, for instance.

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In total, outperforming funds and the groups that run them have little in common. On average, however, their lead managers share a single characteristic: on average, they have run their products for far longer than the industry mean, or seven and a half years. The lead manager on the median fund has managed it for six years and nine months – still double the mean of roughly three years, Hughes says. “Part of the problem as time has progressed is that people are getting more and more short-termist,” he told Fund Strategy before the figure was first published. “The pressure to deliver a good one to three-year number, and hope that translates into a good five-year number, has increased over the last five to six years. If you’re getting heat from your chief investment officer every quarter, that pressures you into delivering short-term outperformance.”

”The pressure to deliver a good one to three-year number, and hope that translates into a good five-year number, has increased over the last five to six years”

One of investors’ major problems, Hughes and Burdett contend, is that they are supplied with an ever-increasing quantity of short-term information, which can push them into making short-termist decisions. Burdett adds, however, that fund groups can counteract this problem if the manager holds a locked-up stake in the business, giving them a financial incentive to stay. The number of funds that met the criteria and featured the same lead manager over the five years is, predictably, low. Only 150 funds met this test – coincidentally, the same number of funds on Hargreaves Lansdown’s Wealth 150 recommended list. Only 28 funds feature on both lists, with three from M&G and four from Neptune.


For savers, the main conclusion from the survey is that there is no large sector or group where they can stick a pin in their fund ranges and hope, on average, the results will outperform their five-year objectives. However, individual groups have a reliable record in set sectors – Neptune in global equities, First State in Asian emerging market equities, Jupiter in multi-manager, Ruffer in multi-asset and M&G in sterling corporate bonds. Some of the best performing groups, such as Slater, may run tiny specialist outfits, but their focus can provide comfort for investors.

Crucially, the calls on markets that have delivered outperformance and preserved capital have proved tough and often go against the grain of events. When asked to name the top five contributors to returns on his outperforming Threadneedle Equity and Bond fund, Alex Lyle says the firm had to favour Asian and emerging market equities throughout the period, despite vicious swings, and, until recently, underweight Japan, despite enticingly low valuations. On stocks in general, Threadneedle’s managers had to adopt a cautious position in 2007-2008, a positive stance in time for the rally of 2009-2010 and then focus on companies with strong balance sheets during the recent turmoil.

Even the most established groups may struggle to replicate these kinds of calls in future. Conversely, this gives fund managers that have underperformed a chance to catch up. Most groups have a corner of their range that has met the criteria and could provide seeds for future results. Of the top 30 fund groups in terms of assets under management, only Artemis and HSBC have no British retail funds meeting the criteria. Looking at the top 40 adds only Co-operative, Santander and Skandia.

Despite poor results over the past five years, the industry has learned many lessons that may enable it to perform better.