“Closet tracker” is one of the most derogatory and unhappily relevant terms in the financial sphere. It describes a fund that merely imitates its benchmark. It implies inability and even downright deceit – an ugly combination of expensive fees and unexceptional performance.
There is an emerging school of thought that such funds constitute mis-selling on a vast scale. Many are innately powerless to add alpha. The use of simple, low-cost index funds has made them all but obsolete. The more recent development of enhanced-index products that are capable of generating returns above those of benchmarked indices has only added to the pressure.
As a result, uncomfortable questions are being asked about the role of many equity funds in portfolios. If closet trackers are an example of fund “management” at its most unthinking then what approaches are to be found towards the other end of the scale?
Confrontational or counterintuitive?
One answer is contrarianism. A contrarian philosophy seeks to beat the index by delivering not just strong, long-term, risk-adjusted returns but diversification. By definition, contrarian investment managers should embody the diametric opposite of their closet-tracking, herd-following counterparts. What, though, makes a successful contrarian investor?
A true contrarian is not merely someone who stubbornly disagrees with anything anybody else says. A person who unfailingly defaults to the discarding of others’ points of view and ideas – and, worse still, who does so without volunteering viable alternatives – is less a contrarian and more a pain in the backside. There is a subtle yet incontrovertible distinction between being confrontational and being counterintuitive, between unthinkingly dismissing orthodoxy and meaningfully challenging it.
A rare breed
Contrarians are scarce in any walk of life – they must be, otherwise they would not be contrarians – and in the investment world they can sometimes seem elusive, as a Financial Times article about stock-picking observed in April 2016: “Contrarianism remains as rare as ever.”
We could be forgiven for finding this surprising at a time when it appears uncommonly clear that to beat the market you have to be different to the market. It is no secret that investors face mounting challenges in the form of low interest rates, relatively subdued growth and occasionally high volatility.
Fixed-income investments, once the 'safe haven' of choice for the risk-averse, now hold limited appeal. Equities retain a capacity to outperform, but how can this capacity be harnessed to best effect?
We should not forget, too, that a low-growth environment such as the one in which we find ourselves now reduces the margin for investment error. Mistakes are less costly when high returns can help absorb the disappointment. Wrong moves are more keenly felt when there is no cushion to soften the blow.
The reality is that the search for returns nowadays demands ever more imagination, ingenuity, conviction and maybe even courage; and yet a growing number of investors might feel many actively managed funds conspicuously lack these qualities. A portfolio consisting entirely of copycat, one-size-fits-all, index-hugging investments invites mediocrity or worse.
At this point it is imperative to reiterate what contrarianism is not. It is not rejection purely for rejection’s sake. This is especially important in an investment context, because a contrarian’s opinions must tally with market sentiment at some juncture if a strategy is to succeed.
It is uncanny how neatly the enemies of contrarianism correspond to the “management” of some funds. Dissatisfied investors might well agree that closet trackers and other products offer grim testament to the law of least effort; that their workings are substantially constrained and practically bereft of original thought; that they resolutely ignore the opportunities a more imaginative approach might present; and that they are little more than a glorified yet ill-disguised brand of herd-following.
Devilment or discipline?
If contrarianism is integral to a move towards the more rewarding extreme of the active management continuum, as we contend, then what should the underlying driver of our journey be? At its most basic, contrarian investment involves buying when others are selling; but remember that true contrarianism is about redefining the consensus rather than unrelentingly opposing it. We want to be proved right, which means our decisions must stem from something disciplined and rigorous rather than from an unfocused desire to contradict for the sheer devilment of it.
There are numerous strategies for fund management. Some investment managers look for historical patterns in the movement of share prices; some react to momentum and buy stocks that are going up; and some, as we have seen, track benchmarks – whether in a passive or allegedly active sense. Although most have their merits, one methodology that particularly lends itself to contrarianism is a valuation-based approach.
If contrarian investment is to succeed then it is necessary to (a) buy when others are selling and (b) disprove and reform the consensus. By trying to establish the intrinsic value of a business and purchasing shares when their price is well below that value, as we espouse, managers can realise both of these objectives and more besides. This, we say, can help minimise risk and potentially enhance returns.
Past vs future performance
Conversely, many fund managers invest in “quality” businesses, regardless of price, on the strength of historic performance. They reason that these businesses have delivered in the past and will do so again.
It is our opinion that the best business on Earth can still be a bad investment if its shares are bought at the wrong price. Equally, a “bad” business can become a good investment if, in keeping with our contrarian philosophy, its shares are bought at a price that is sufficiently low.
The fortunate truth for active stock-pickers is that markets are not always efficient and humans are not always rational. This is why businesses are mispriced; and this is where contrarianism enters the fray to best effect.
Those investment managers who are prepared to apply the discipline and imagination needed to identify valuation opportunities can help turn the tide of unimpressive returns in a low-growth world.
Those who are content simply to follow convention, meanwhile, must continue to tread water or be left to sink without trace.
Over three years to the end of January 2017 the fund has returned 47.84% in GBP.
Together they also run a US domiciled version of the fund, the Invesco Global Opportunities Fund;A which has returned 13.4% in USD over the same three year period.
Over one year to the end of January 2017, both managers are ranked within the first decile on a one year risk-adjusted basis against their peers in the Equity –Global sector.
Comments were taken from a whitepaper penned by the asset manager titled: Daring to be different.