How mixing and matching fund styles can pay off

As recent market moves have demonstrated, it's important for investors to build portfolios that reflect their tolerance for risk, but also that are diversified and resilient in the face of changing market conditions.

Taking Europe ex-UK equity markets as an example, and emphasising the longer term, we have seen a shift in market leadership over recent years. Prior to the last three calendar years when value investing has come to the fore, the Europe ex-UK equity market, like many around the world, was driven by growth stocks. In fact, the MSCI Europe ex-UK Growth Index outperformed the value variant of the index in the previous five calendar years.

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One of the funds on the ii Super 60 list, Fidelity European W Acc , did an excellent job during that time, outperforming the market from 2017 to 2021 when the growth style was in favour, and even managing to show relative strength in 2022 when many growth stocks faltered.

The fund benefits from a highly experienced manager in Sam Morse, who has been managing money in a similar style since 1994 and has been at the helm of this strategy since December 2009. Support is provided by a co-manager and the extensive Fidelity analyst team, which both managers heavily utilise for idea generation and monitoring, and as an input into the research process.

Morse has developed his own stock selection criteria focusing on a company’s ability to grow its dividends, which he views as an indicator of the potential to provide steady cash flow growth over the long term. This results in a portfolio that has a higher price-to-earnings (P/E) and return on equity (ROE) than the index and a beta (a measure of volatility) below one.

Given these biases, we would expect good returns relative to the market in growth-led phases, but value-led markets, such as 2016 and the period 2022-25 year-to-date, provide a headwind and over these periods the fund has shown underperformance. 

How to protect against style risk

One option could be to switch between value and growth-biased funds according to market conditions. Unfortunately, this is more difficult than it sounds! And various studies have highlighted the difficulties of consistently timing such market shifts. As a consequence, most professional investors do not attempt to capitalise on such shifts in a meaningful way, instead preferring to stay invested and relying on portfolio diversification to produce returns across different market environments.

A simple way to improve diversification within equity regions is to allocate investments across funds with different investment styles, such as value and growth. This is a broad way to identify managers who focus on particular types of stocks, and by selecting those with different styles we can create efficient portfolios through combining funds that produce excess returns with low or negative correlations. In other words, as one fund’s style falls out of favour, the style of another manager should come into favour, offsetting any weakness in relative returns.

As an example of what can be achieved with actively managed funds, we can go back to the Fidelity European fund on the ii Super 60 list. To balance the dividend-growth stocks held in this portfolio we need to identify a manager who has been successful in buying stocks with lower historic growth profiles and lower valuations.

One option is the JPM Europe Dynamic (ex-UK) fund, which is available on the ii platform. This fund is run by a team of four led by Jon Ingram, a position he's held since 2007. An established quantitative model forms the core of the stock selection approach and uses various factors to identify stocks with attractive quality, value and/or momentum characteristics. This is combined with qualitative oversights from the direct fund management team and the wider research teams at JP Morgan that add a forward-looking element to the process.

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Looking at the detail of these two portfolios and comparing the underlying holdings, we see minimal overlap, with just eight common holdings from the 43/68 total number of stocks in the two funds.

We would expect that combining these two high-quality funds would produce an attractive outcome, and this has been shown to be the case historically. Buying both these Europe-ex UK equity funds with a 50:50 weighting produces good returns, with underperformance in just two of the last 10 calendar years.

However, further assessment of aggregate outputs over time, such style and sector exposures, shows that a split of 60:40% in favour of the JPM fund produces a portfolio with acceptable relative risk. In terms of relative returns, this combination shows more historic consistency than that available from the individual funds. Underperformance is seen in just one calendar year in the past 10 compared to the individual funds that both outperformed in three calendar years. Given the established investment processes used on these funds and the consistency of their implementation, it is reasonable to have high expectations of similar results going forward.

Combining active managers can therefore mitigate the impact of swings in market leadership, and help investors sleep at night.

Simon Dorricott is director in the manager selection team at Morningstar.