Why investment funds fail, and how they can turn from zero to hero

Tom Bailey examines why some funds and trusts fail, and the factors that can enable recovery.

A turnaround in a fund’s performance usually happens for one of two reasons.

The first is a change in the market or the macroeconomic environment. Certain types of stock are favoured in particular conditions. For example, growth stocks usually perform better in periods of low interest rates. Similarly, the broader economic perception of a region can affect the share price of most companies based in that region, a case in point being domestic UK stocks in the years following the Brexit vote.

The term ‘factor’ can be used to describe a mutual characteristic of certain stocks that causes them to rise or fall. It can be either a macroeconomic or an investment style factor. A fund’s performance may therefore pick up if the factors to which a fund manager is exposed return to favour, in what is often called a factor rotation.

A second catalyst is a change in management. When funds have suffered a prolonged period of underperformance, its management is often replaced. A change in management may involve putting in place a manager with greater skill or one who will reconfigure the fund’s exposures and change its investment style.

Below we examine some funds and trusts that have performed poorly lately, and ask whether and why a turnaround might be on the cards.

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Style stumbles

One of the clearest examples of a fund underperforming because of its factor exposures is the Artemis Global Income fund, which returned 16% last year. That performance is not to be scoffed at. However, Dzmitry Lipski, head of funds research at interactive investor, says: “The concern lies in its longer underperformance relative to the sector average and benchmark (FTSE All Country World index) in recent history.”

However, John Monaghan, head of research at Square Mile Investment Consulting and Research, says its poor performance is “explicable in the context of the manager’s investment style”.

The fund’s manager, Jacob de Tusch-Lec, favours companies that are both undervalued and have a history of paying dividends. Companies he views as overvalued or that do not pay dividends are excluded. Over the past decade, US technology companies have massively outperformed. However, because they are highly valued and rarely pay dividends, the fund has avoided them.

Monaghan says: “De Tusch-Lec has preferred to tilt the portfolio to Europe (excluding the UK), where he thinks companies are far more attractively valued. Performance in the region over the past five years has lagged the S&P 500 by a considerable margin.”

He adds: “Given how the fund is currently positioned – which broadly speaking favours Europe over the US at the geographical level and financials over technology from an industry standpoint – we would expect the fund to continue to lag, should the US market continue to outperform. However, we think the fund is well-placed if the US market underperforms other major equity markets, particularly if European markets pick up the running.”

Indeed, having the ‘wrong’ factor or geographic exposure has been a common factor in the underperformance of many funds in recent years. Broadly, funds that are underweight growth stocks have underperformed. “Growth has been the place to be,” says Scott Spencer, an investment manager in BMO Global Asset Management’s multi-manager team.

Spencer also highlights other factor exposures that have led to the underperformance of certain funds. He attributes Schroder US Mid Cap’s disappointing returns to the continued outperformance of large-cap stocks in the US over the past decade, for example.

In the fixed-income space, the best performance has come from long-duration bonds. That, he says, explains the underperformance of the M&G Optimal Income fund, which favours short duration.

Longer-duration bonds are more sensitive to interest rates. Eduardo Sanchez, senior investment research analyst at Square Mile, says the fund could see better returns if economic growth remains positive and central banks start to raise interest rates. However, he adds: “Unfortunately, this is the opposite to what we experienced at the end of February, when the market sold off due to the uncertainty created by the coronavirus.”

Management element

However, the performance of actively managed funds is also affected by the manager in charge and the specific stocks they choose to gain exposure to each factor. That’s why a change in management can act as a catalyst for a turnaround in performance.

Edinburgh Investment Trust was managed by Invesco’s Mark Barnett between 2014 and 2019. Over the past four years, the trust has underperformed significantly: it returned -8.6%, compared with the IT UK equity income sector average of 24.4% and the benchmark FTSE All-Share’s 28.3%. As a result, Barnett has been replaced by James de Uphaugh at Majedie Asset Management.

According to Simon Elliott, head of research at Winterflood, some of Barnett’s underperformance can be attributed to both “stock-specific disappointments and significant weightings to both UK domestic cyclical companies and the tobacco sector”.

Spencer says Barnett had a heavy skew towards value, particularly UK domestic stocks. These stocks have performed poorly since the EU referendum in 2016, though they improved somewhat in recent months. However, even if the market sees a major rotation and such stocks return to favour, the new manager will likely have changed the portfolio and its factor exposure.

Spencer continues: “Uphaugh does have a value inclination, but it’s not as strong as Barnett’s. You are going to get a similar flavour, but a different approach. It’s probably going to be more balanced and have fewer domestic holdings.” He adds that while he expects the trust to recover, this will probably be due to exposure to factors other than those that resulted in the past few years’ losses.

Spencer has confidence in the new management team. He says: “Majedie Asset Management is a team we rate and Uphaugh is a good manager.”

Another example of a change in management being seen as a potential catalyst relates to Schroder Public Private Trust, formerly Woodford Patient Capital. The trust’s mandate was recently taken over by Schroders, following its disastrous performance under Neil Woodford.

Surprise package

According to trust analyst Numis, the appointment of Schroders came as something of a surprise, with the group better known for running funds focused on publicly listed stocks than on unlisted ones. However, it is currently attempting to increase its private equity offerings, having acquired specialist asset manager Adveq, which focuses on venture capital, in 2017.

One common criticism of the trust under Woodford was that Woodford had no background in private equity. His skills as a large-cap value-focused stockpicker were not directly transferable. However, with former Adveq employees now managing the portfolio, the trust’s fortunes might be expected to improve.

So far, however, that has not been the case. One holding, Industrial Heat, added by Woodford was written down in November after Schroders acquired the mandate. Since the appointment of Schroders, the trust’s net asset value has fallen by 14.4%.

Will the trust start to perform better, looking ahead? According to Elliott, the new manager is unlikely to make many changes to the portfolio. He says: “While these are early days, the new management team of Ben Wicks and Tim Creed will be seeking to demonstrate that the trust’s [continuing] investment thesis of taking a patient approach in providing capital to early-stage UK companies is valid.”

A twin-track tale of a turnaround

One of the most prominent examples of a fund staging a dramatic turnaround relates to Fidelity China Special Situations.

The trust was hugely popular at launch in 2010 – bringing in £460 million – but performance soon dipped. Its net asset value was down by more than 30% by early 2011. The fund’s poor performance was a result of global macroeconomic factors and a series of bad stock picks (some affected by an accounting scandal).

The trust started to recover under then manager Anthony Bolton, but since his retirement and the appointment of Dale Nicholls as manager in 2014, performance has notably improved.

This turnaround can be attributed to changes in both the macro-economic environment and management.