It has grown more difficult to spot the lucky from the skilful in the world of fund management as quantitative easing and low interest policies have ‘lifted all boats’, according to AJ Bell’s Ryan Hughes. 
As such, investors need to focus on a fund’s investment process and understand whether it is performing in the way that investors expect it to, rather than on total return alone.
Hughes, head of fund research at AJ Bell, said since markets bottomed out following the global financial crisis equity markets have benefited from a nine-year tailwind.
He said: “I think in the more recent past that has become even more prevalent as we have seen this low volatility market rise where the vast majority of stocks in the market have been grinding higher in a low volatile fashion.”
Hughes said that had created a “relatively benign backdrop for fund managers” who have been able to take on greater risk and deliver decent returns.
Indeed, as the below chart shows, all the major equity markets globally have performed strongly over the past two years, with the top performing MSCI Emerging Market index up by 65.09 per cent while the poorest performer – the FTSE All Share – is still up by 30.09 per cent.
Performance of indices over 2yrs
Source: FE Analytics
In fixed income, the market has experienced a bull market spanning nearly 30 years, meaning that most if not all managers in the space, have had a broadly favourable backdrop for much of their careers.
This has made it ever more difficult for investors to work out which managers have enjoyed their success because they have been dragged higher by the rising tides that have boosted markets and those that have done so through skilful stock selection.
Hughes said there was no one metric that can help, but a combination of qualitative and quantitative analysis enables you to paint the picture.
“The simplest point is ensuring you fundamentally understand what the manager’s investment style is to enable you to do sensible comparisons against meaningful benchmarks,” he said.
“To take a simplistic example, if you took the IA UK All Companies sector over the last 15 years and simply found a manager that had a mid-cap bias on for that period they are highly likely if not almost certain to have outperformed.
Performance of sector vs index over 10yrs
Source: FE Analytics
“So, understanding the manager’s style, their biases and therefore selecting suitable benchmarks to measure them against is a good point to make sure you are not giving them a free pass.”
He also highlighted measures such as the r-squared ratio (which measures how closely correlated a fund is to a benchmark), volatility and Sharpe ratio (which measures risk-adjusted returns) as all good measurements but should be used collectively rather than in a vacuum.
Additionally, Hughes said fund managers have increasingly been making greater mention of active share measure, which measure the percentage of stock holdings the differ from the benchmark and contribute to outperformance.
“While having a high active share is no guarantee of outperformance, I think if they have a high active share they are suitably different to the benchmark and are therefore going to be more reliant on their additions to be able to deliver long-term performance,” he said. “That will help them show an element of skill in their stock selection if that comes through.”
Overall, there are two types of skilful managers: those that outperform consistently, and those that perform as you want them to in various markets – depending on their style and process.
Hughes noted: “When you find managers that have got that element of consistency to their performance that shows that they have got a very robust process that can withstand a wide variety of different market conditions.
“But you also see managers that are not consistent but when their style is in favour they win handsomely, so you can come at that in a few different ways and both might be seen as equally skilful but their return profile might be very different in how they go about that return.”
An example of a consistent performer for Hughes is the £4bn Threadneedle UK Equity Income run by Richard Colwell, which has been a top quartile performer in the IA UK Equity Income sector over five years and a second quartile performer over one- and five-year periods.
Performance of fund vs sector and benchmark over since manager start
Source: FE Analytics
“As an income style Richard Colwell has been managing that fund for seven years and when you look at it you can see the level of consistent performance,” Hughes said.
“You have a nice repeatable process and while it hasn’t gone up in a straight line over the period you know exactly what you are getting when you buy that approach, in terms of how he goes about things.
“He is generally there or thereabouts in every market condition; he has outperformed in rising markets, outperformed in benign markets and protected on the downside when things have been difficult as well.”
He said the manager scores well on measures such as alpha generated, Sharpe ratio and r-squared but interestingly wouldn’t necessarily have a high active share due to his process, noting that “you do not necessarily need to have a tick in all of the boxes to find that type of approach successful”.
Conversely, a manager that has had a tougher time but that still has shown skill is Jupiter’s Ben Whitmore, who runs the £1.8bn Jupiter UK Special Situations fund.
“He is a manager that when value is in favour has demonstrated over a very long period of time that he can win very well through an almost metronomic application of an investment process,” Hughes said.
“What that does mean is you will get various years where he is absolutely fourth quartile of the pile – he had one of those in 2015 and then 2016 you had the value rally and he is significantly ahead of the sector.”
Again, the fund is another where the active share is not necessarily at the top end but is higher than some but comes out strongly on other measures such as Sharpe ratio, beta and alpha.
Overall, Hughes said it is difficult to work out the skilful from the lucky as much of the analysis is backward looking, and asset allocation from investors is just as crucial.
“I would hope that the skill in fund selection is also bringing in the element of asset allocation where if you can combine the two you can find skilful managers that can exploit that opportunity set at the right time,” he said.
“I absolutely understand that there are points in time and market environments where if you get a rising tide that floats all ships then good stocks and bad stocks can rally in that and it doesn’t matter where you are invested you are still going to benefit.”
Hughes said his preference was to find skilful managers and blend them together, arguing that over time this approach will provide better risk-adjusted returns.
He added: “In some respects I am not fussy about how I get my return as long as I get it, but at some point it will matter whether it was luck or skill.”