Boutique puts the boot in

Somerset Capital Management, one of a diminishing pool of fund boutiques that still thrive, is being taken seriously as a challenger to the behemoths of the emerging markets sector

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Regulatory and cost pressures have diminished the pool of genuine boutique fund management groups. Relatively few have managed to build sufficient scale to remain viable. One of the few to thrive in the recent market environment has been Somerset Capital, despite its exclusive focus on the unloved area of emerging markets.

Perhaps more impressive has been its emergence as one of the genuine challengers to the behemoths of Aberdeen and First State within emerging markets. It has just four funds: the EM Small and Mid Cap and EM Small Cap funds are now closed, but the remaining two – the Emerging Markets and Emerging Markets Dividend Growth – have produced consistent top decile performance since inception.

Somerset was founded in 2007 by a group of ex-Lloyd George executives and investment managers. Chief executive and founding partner Dominic Johnson has been vocal in his desire to build a business where the interests of fund managers are genuinely aligned to those of their investors. He has been part of the New City Initiative, a think-tank comprised of independent asset managers from across Europe who believe that excessive regulation is damaging the interests of investors.

When he set up the firm he wanted to introduce a new type of culture. As a result, the group was built with a specific structure: It is built as a partnership, with just a couple of external shareholders. This means that all of the 10 investment managers – split between London and Singapore – all have a substantial (5 per cent to 20 per cent) stake in the firm. Johnson says this creates more prudent management of risk and a sense of collective responsibility. If one fund managers makes poor choices, the guy he sits next to suffers too.

Oliver Crawley, partner and head of European and Middle Eastern marketing at the group, says: “We wanted to avoid silo-ing fund managers. Everyone draws their income from the same pot. It ensures that every stock that goes into our portfolios is torn apart and rebuilt by every fund manager. Equally, a percentage of our drawings above a certain threshold are paid into a members’ benefit trust, investing in the group’s funds, which is a further incentive to perform.”

He adds: “We spent 15 years thinking about the best way to do this and it is so important to get it right.”

The result, says Crawley, has been a unique trust between clients and fund managers. The group now has £2.6bn under management and has never lost an account. He says that even within the funds, turnover has been less than 2 per cent: “We believe our investors are genuinely long-term,” he adds. The two founding investors – a Canadian Pension fund and the Alfred Dupont Testimonial Trust – are both still with the group and also hold a stake in the business.

Crawley says: “The profits remain in the business. No-one is forcing us to launch new products. The psychology of the business is very different. It aligns us with our clients and as such, we do not find alpha eroded over time.”

The group has taken the same view on fees. The total expense ratio for its funds is 1.25 per cent, lower than the market average and for the most part, it does not matter who is investing, they pay a similar rate.

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To date, many of the group’s assets have come from the institutional market, but Crawley says they are keen to develop a more balanced distribution base, diversified by country, currency and client type. In practice, this means building up the two Ucits funds that remain open – the Somerset Emerging Markets Dividend Growth fund and the Somerset Emerging Markets fund.

For the time being they have plenty of capacity – about £2bn in each fund, but the Aberdeen and First State experience shows that demand for emerging markets funds can come suddenly. The smaller companies and small and mid cap funds closed at £400m and £800m respectively. Crawley says: “Capacity is very relevant in emerging markets. The larger you become, the more difficult it is to outperform – your opportunity set reduces.”

The group is building traction with multi-asset managers such as Gary Potter and Rob Burdett at Thames River, David Coombs at Rathbones and Graham Duce at Aberdeen. The next phase is to look at a more retail audience. The group is on the Hargreaves Lansdown platform and is in discussions with a number of the retail distributors.

The investment process remains consistent across all the funds. They hold 40 stock, low turnover, benchmark agnostic portfolios, built from the bottom up. Turnover in some cases is as little as 20 per cent per year, so only eight to 10 new ideas might be introduced in a single year. The investment managers focus on absolute rather than relative returns and the country weightings look nothing like the benchmark.

Crawley says: “No country weighting is over 10 per cent, whereas in the index, South Korea, China, Brazil and Thailand all make up from 12-17 per cent of the index. There are so many opportunities in global emerging markets that we do not feel we need to put 25 per cent in China to make money.”

The Somerset Emerging Markets Dividend Growth fund is now a significant focus for the group. The group first decided that they wanted to launch it in March 2010 but could not find anyone to back it. They gathered £1m between the partners to seed the strategy and their faith has been rewarded. The fund has delivered over 20 per cent ahead of its IMA Global Emerging Markets sector peer group over the past three years and is now £288m in size.

The dividend fund aims to buy companies that are going to sustain a dividend yield and every stock in the portfolio is expected to pay a yield. The companies are not selected on nominal yield – Crawley says that the managers can find plenty of companies that can produce a 7-8 per cent yield, but are simply too high risk for their appetite.

He says: “They would be buying miners and banks and it is not the best way to secure a sustainable yield. We are trying to grow the dividend believing that that will drive the capital value of a company. We are more focused on the dividend than the share price.”

The fund currently pays a dividend of about 3.5 per cent. This may not be high in absolute terms, but Crawley says that if they can grow that dividend and take care of the capital side as well, then investors should be happy with their investment.

He says of the group’s philosophy overall: “We want to produce a fund that an investor could not replicate himself. We could own companies such as Unilever – and it is undoubtedly a great company – but investors would probably hold it elsewhere in their portfolios and would not necessarily be expecting their global emerging markets managers to buy it as well.”

As a result, the top 10 holdings in any of the Somerset funds are unlikely to be Samsung, Petrobras, or any of the other emerging market behemoths.

But a significant criticism of the Aberdeen and First State funds is that they have benefited from their preference for ‘quality’ companies over the past few years, which may not be sustained if economic momentum picks up. Somerset also has a bias to quality companies. So is Crawley worried that some of their favoured companies may now be trading on extremely high valuations?

“Certainly those companies that offer quality, growth and a high yield have been bid up by the market since 2011,” he says. “However, given the size of our funds, we can find some opportunities that are simply too small for the larger funds.”

Stocks are equally weighted in a portfolio and therefore if one company’s share price moves 80 per cent higher, it can add as much as 2-3 per cent to overall portfolio returns.

Crawley adds: “It is much easier to move up by 80 per cent if a company’s overall market capitalisation is $1.5bn, rather than if you are significantly larger.” He points to companies such as AFP Habitat, a Chilean life insurance company with a market capitalisation of $2bn, but with daily liquidity of just $4m: “This is simply too small and illiquid for a large manager.”

The early founders took two pieces of advice from hedge fund veteran and boutique head Crispin Odey when they started out – do not grow too big, and stick to your knitting. Somerset Capital is unlikely to be branching out into UK equities or cautious managed funds any time soon. Crawley says they may consider running an emerging Asia strategy out of the Singapore office, or a proper global fund with a high emerging market weighting. He also says the group may ultimately launch an investment trust. However, these are long-term plans and the group’s focus in the short-term is building scale in the Emerging Markets and Emerging Markets Dividend Growth funds.

It has been a rocky few months for emerging markets, but Crawley says fund flows have held up well. He says: “Over the past five months, we have had net inflows almost exclusively, with just a few days of net outflows. It has been steady money from steady sources.”

Somerset has faced down some significant challenges in its first six years of existence: It has shown strong performance when its asset class has been struggling, it has built scale when fund flows have been erratic and it has sustained its boutique model at a time when it has become increasingly difficult to exist as a smaller asset management business. The future can surely only be easier for the group.

The independent views

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Mona Shah, fund manager, Rathbone Multi-Asset Investments

“We were early supporters of Somerset Capital Management, set up in 2007 by a team from Lloyd George, and who have worked together for several years. They now manage several billion, from London and Singapore, across emerging markets. The portfolios are concentrated; they charge a low, flat annual management charge, with no performance fee. We like the fact the investment process is very index-agnostic. The team conducts in-depth research by visiting companies and constructing their own models, using external research only when it adds value. Even if the macro fundamentals look interesting, the team will not invest if there is nothing sufficiently attractive. The size of the team is mitigated by a strong process of peer review to challenge decisions. Somerset Dividend Growth, in which we are invested, is managed by Edward Lam. This was Lam’s first role running money and he has shown himself to be a highly competent manager. We are supporters of boutique approaches and Somerset ticks our boxes.”

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Patrick Connolly, certified financial planner, Chase de Vere

“Somerset Capital was formed only six years ago, by members who were previously in the Lloyd George management team. They have made some good progress over that period with their focus solely on emerging market equities. UK retail investments represent a small proportion of their total assets under management, as they also run money for US state pension funds, the Canadian government and in Australia and Europe.

”They are gaining more credibility in the UK with their bottom up stockpicking process focused on large cap companies, ignoring benchmarks and low turnover. The geographical breakdown of their funds is usually different to competitor funds, without a huge weighting in the Bric countries, meaning they can provide good diversification alongside other emerging markets funds.

“Currently the emerging markets have gone sour, and while this can create investment opportunities for them to exploit, it also means that investors are less likely to invest, which is a potential problem as Somerset Capital is reliant on the emerging markets.

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Gary Potter, joint head of multi-manager, F&C Asset Management

“As a company it is not huge. It has got a manageable amount of assets under management relative to its peer group and it is quite compact as a business. They have very experienced fund managers, that have come from Lloyd George. We hold the Dividend Growth fund, run by Lam. It is pure quality – they bring incredible rigour to the analysis of companies and it reminds me very much of the First State approach in its formative years. The team is motivated, the funds are quite nimble and it is a relatively new entrant in the market. They have capped the smaller companies fund, and we like that they are prepared to cap funds.

 

Somerset Capital

Somerset Capital is a boutique emerging markets specialist. It was founded in 2007 by chief executive Dominic Johnson and a number of ex-Lloyd George investment managers. It has built £2.6bn under management since inception and has four Ucits funds available to retail investors.