When to give up on an underperforming fund

Cherry Reynard | 10 Jul 2019

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Investors often have to put up with periods of underperformance, but as the unwinding of Woodford shows, you can't wait indefinitely for a fund manager to turn the ship around.

The very essence of active investing is that markets sometimes get it wrong. The active investor spots the anomaly and waits until the market catches up, revaluing the shares at a higher price.

But how long should investors wait for that to happen?

The question is pertinent today in the wake of the problems at Woodford Investment Management. Neil Woodford has long defended the holdings in his portfolio: “Throughout financial market history, there have been occasions in which markets have become completely detached from valuation reality. We believe we are in one of these periods right now, with bubble-like characteristics increasingly evident and adding considerable risk to the investment backdrop,” he says.

“Ultimately, fundamentals are like a gravitational force that pull markets back into alignment with reality. That is why bubbles burst. Fundamentals always reassert themselves in the end.”

Some parallels can be drawn with the late-1990s technology bubble, when investors gave Woodford time and were rewarded. However, this time, it has taken too long for those fundamentals to reassert themselves and investors were not sure if the problems were short-term or whether Woodford had lost his edge.

But even if share prices of the stocks in the Woodford portfolio do start to reflect fundamentals, many investors may argue it was not worth the pain in the interim.

Structural change vs market fashion

How do investors know whether they should cling on in the hope that share prices will revert to historic norms?

You need to draw a clear distinction between structural change and market fashion, says Andrew Impey, a director at UK-based OLIM Investment Managers.

"Structural change is very different. Retail companies, media companies are subject to significant change, and then you do have to change your mind. That’s not market fashion and they won’t go back to the way they were before. These companies need to change their business model significantly to survive.”

The same is true for fund managers. Gill Hutchison, research director at the Adviser Centre says the decision to hold or sell a fund depends on whether it is struggling because of style or “fashion” factors, such as small caps falling out-of-favour or  value investing struggling, or because the manager is underperforming in isolation.

In Woodford’s case, investors may have been alerted to the problems because his performance was that much worse than that of his value-focused peers, such as Clive Beagles at J O Hambro Capital Management, or the Schroder Income team.  

Hutchison says: “If a fund’s performance is struggling because its style is out-of-fashion, we understand. However, if performance is struggling for factors that do not appear to relate to its mandate and natural style, we become nervous and conduct further analysis to identify whether stock or sector-specific issues explain the outcome.”

Investors should always be alert to those pedalling the line “this time it is different”, says Fahad Kamal, chief market strategist at Kleinwort Hambros, Societe Generale's UK-based wealth management division.

Such sentiment currently features in investment markets, as investors argue that high valuations for certain growth stocks can be sustained because of low interest rates and the influence of disruption.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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