Editor’s introduction. There are valuable lessons to learn from Chris Cuffe’s experience with the Third Link Growth Fund. The Fund’s managers are selected by Chris in a ‘fund of funds’ structure, and all fees paid by investors go to charities.
Although the Third Link Growth Fund has been a success, if I’m honest with myself, after seven years and with one of the best track records in the market, you would expect it to be bigger than its $85 million. I’m proud of the pioneering structure, where the fund managers provide their services for free, enabling us currently to give more than $100,000 a month to charities. That’s obviously a great story, but why has more money not flowed in?
Answering this question highlights some big lessons about investment management.
1. Financial services are sold not bought
In commerce generally, the consumer finds the best products in the market, especially with such an open system as the internet. But financial services is an industry where products are sold not bought. There are a lot of middle men and women doing the selling. People struggle to find the best products in the world of investing.
If a fund does not have active sellers and marketers, it doesn’t get much support and that’s how it’s worked out. Listed Investment Companies (LICs) have broker networks that work their clients intensely in the offer period, while dealer groups have advisers who tell their clients where to invest.
In the pre-FOFA time when this Fund was launched, it paid no commissions, and most advisers were commission-based. We’re not really long into the post-FOFA environment, but I don’t think advisers scour the earth looking for the best products. They have to do the right thing by their clients, but that does not mean finding the very best. It’s more what’s on their radar screens.
2. Joe Average doesn’t have a clue where to invest
In financial services, with most aspects of investing, Joe Average does not have a clue where to start to find the best products. To DIY in financial services is tough for the average person. I can DIY in my back yard by going to the hardware store, working out how to pave a path or tile a wall, but you can’t do that easily in financial services.
3. The environment and structure must be right for the product
Third Link does not have sales support other than me telling the story (and I do this pro bono and have limited time given my other activities) and the occasional press coverage, and it lost some of its initial impetus due to the impact of the GFC. The environment must be right for the product. My Fund was more suited to a one-off big bang, a press event, a launch with a room full of people, sell it and close it quickly on the back of a heap of publicity. I don’t think it suits a slow burn of continuous fund-raising over many years. Whether you like it or not, a slow burn means being on the major platforms, financial planner support and a sales force of business development managers. And stockbrokers don’t support managed funds.
Third Link is rated only by the Zenith Group and it’s only on one platform (the BT platform) to allow people to have a superannuation version. Platforms create administrative work and everyone helping out with Third Link is doing it pro bono, so I have not sought out other platforms.
4. Blending styles is a waste of effort
In my view, professionals blend managers in multi manager funds in exactly the way that gives a mediocre result. Typically, they will blend value managers, growth managers, large managers, small managers, etc and then wonder why they achieve the index less their fee. The results of these blended funds have never been great.
I am not the slightest bit interested in blending styles and so some people are put off Third Link because there is no formal scientific process. My process is called experience – one of finding competent, proven managers who will swing the bat and have a go. I do watch for concentration risk but I’m mainly interested in the willingness of managers to pick stocks ignoring the index. In fact, I like to see a high tracking error which is the opposite of most professionals.
5. Past performance is the best guide to future success
Every offer document in the country says something like ‘Past performance is no guide to future performance’ or similar. That is exactly the opposite of how I think. It’s the best guide to knowing what a manager is really like over a long period. Past performance is extremely important and a great guide to the future.
Only long-term results are relevant. The managers I use are selected for the long term. I have no interest in their short-term results. If it looks like a manager is struggling (which I would only conclude after rolling 3-year periods), I would only exit after say a poor rolling five-year result.
6. Never buy a bad stock because the price is low
I don’t like ‘deep value’ investing where a manager is willing to buy a poor quality stock because the price is so cheap. I don’t like people saying a bad stock priced cheap is low risk. I would hate to see any of the stocks held by my managers fall over.
Managers need to buy quality stocks. Adding that to a good track record and a high tracking error should mean my fund will do well in falling markets (which it does) which is a sign of a good portfolio.
7. Watch the level of funds under management
I do look at total funds under management in a manager and the types of stocks the manager buys. A small cap manager in Australia with more than $1 billion concerns me. And I am cautious about investing with a larger cap manager in Australia with more than say $6 billion under management. At that level, I need more convincing. Size can get in the way of performance. It’s no coincidence that most of my managers have performance fees, which enable them to remain smaller while making it economically viable to run their business.
Most managers talk about staying below capacity and refusing to take in more money but my experience is most don’t do that, especially when there’s an institutional owner. It’s compelling to take more money. Boutiques are best at watching capacity as they can make a lot of money from performance fees if they are good.
8. Don’t be afraid of performance fees
I believe managers deserve their high fees based on their performance. In my own personal investment portfolio, I don’t care about paying a 20% performance fee (as long as the right hurdle exists) if I’m getting 80%.
It’s a great part of the Third Link structure that the managers kindly refund all the performance fees, as well as the management fees. It’s the sizzle in the Fund. For most professionals who provide a fund-of-fund product, the underlying fee of each manager is so crucial for their own economics that they cannot pay performance fees. But I’m agnostic to fees so I just look for the best managers.
I have not selected any of the managers based on their willingness to forgo their fees. I select on merit then ask if they will waive their fees. I will restrict the Fund’s size to about $150 million so no one manager has more than about $20 million.
9. Active versus passive depends on the asset class
The active versus passive debate is not a one-size-fits-all. It should be considered in the context of the asset class. In Australian equities, I’d never invest in a passive fund. You have to look at the index before you go passive. Why would you buy an index which is 30% in banks (mainly four stocks) and 15% in resources (mainly two companies)? Talk about a risky portfolio! It amazes me people would start with that. But internationally, say the MSCI World Index, index investing has merit. In Aussie small caps, you could invest in an index fund but I think there is no upside in having small resources because of their boom and bust track record. And I think the active managers of small cap industrials generally do better than the industrials index because they can find small under-researched stocks. But there’s nothing wrong with indexing in parts of the fixed interest asset class.
I hope some of the roboadvice models use active management, especially in Australian equities, but I suspect they are unlikely to do so due to the cost.
10. Business risk guides a lot of investing
It’s astounding in Australia the number of managers who won’t risk being too different from the index. If they underperform for a short period due to departure from the index, they worry they will lose funds (and maybe their job will go as well). If resources and banks are not doing well, a fund with managers that are index unaware should do well. The best three months of relative performance of Third Link in its history was the last three months as both these sectors fell.
I listened to an active Australian equity manager tell me how proud he was of being index-unaware, yet his exposure to financials was 27%, not the 30% per the index. This is not an active position at all and he is surely being driven by the index. I would think that a position of half or double or nil is more like an active view.
This benchmark risk (that is, the lack of willingness to be different from a benchmark) has a lot to answer for in encouraging mediocre investing across the world. The dominance of these behaviours is far greater than anyone will admit. It drives many professionals to bizarre investing.
I don’t have any business risk or career risk in selecting my managers. Third Link is not a business and I’m running only one fund.
The best investors I deal with are totally benchmark unaware, even as to what markets they invest into, local or overseas or cash or whatever.
Chris Cuffe is the co-founder of Cuffelinks and has a wide portfolio of interests across commercial, social and charitable sectors. More details on the Third Link Growth Fund, which has consistently outperformed its benchmark, are on www.thirdlink.com.au. How can we have a disclaimer after such firm opinions? Let’s just say anyone should seek professional advice on how these lessons apply to them, as the circumstances for each investor are unique.