Most fund managers have their remuneration tied to how they perform relative to an index. Underperformance is tied to outflows in funds which limits the management fees they collect. Enter closet indexing. An approach where the managers avoid deviating too far from the index or their peers.

Furthering the temptation to stay relatively closely aligned to an index is the fund mandate or rules that govern how a fund invests. These mandates must be followed to ensure that investors in the fund are fully aware of what they are getting into when they invest. They also allow investors to match a fund to a specific exposure they are trying to achieve in their portfolio.

These two factors mean it is rare for a fund manager to have the full discretion to invest in their best ideas. We have selected two funds focusing on small/mid caps awarded a Gold Medalist rating* by Morningstar’s Manager research team that have deviated from the index to build large positions in a single holding.

These holdings deviate from the index and their benchmarks, indicating bullish sentiments from the fund managers.

We explore how these outsized positions stack up against our equity analysts’ research.

* A gold medallist rating reflects our forward-looking assessment of an investment strategy, including an assessment of the People, the Parent company, and the Process. The five tier rating system spans from Negative, Neutral, Bronze, Silver and Gold. A gold rating indicates a strong expectation from our analysts that the investment will produce positive alpha relative to its Morningstar category index over the long term.

ICE Fund: GUD Holdings GUD

  • Fund exposure: 5.01% (at 31 December 2023)
  • Benchmark: S&P/ASX Small Ordinaries TR AUD
  • Benchmark holding: 0.6%

ICE Fund receives the top rating from our Manager Research team. The fund gravitates to small cap stocks like GUD Holdings, but investors looking for small cap exposure should be aware that the fund is market-cap agnostic. Manager Research Director Michael Malseed believes that the fund has an attractive fee structure relative to peers, and a solid team, process and parent company.

The strategy is benchmark unaware, which is demonstrated by the large holding in GUD. The fund adopts an investment process focused on finding quality companies with reliable growth and durable competitive advantages. The team also looks for companies with entrenched market positions or with assets (including licenses, patents, and brands) that are hard to replicate.

What Morningstar equity analysts think about the share

GUD Holdings GUD ★★★

  • Moat: None
  • Fair Value: $12 (current price $11.17*) We consider GUD trading within a range we consider fairly valued
  • Investment style: Small core
  • Sector: Consumer Cyclical

GUD Holdings GUD owns a portfolio of companies specialising in the automotive aftermarket and accessories sector. Through its two business segments, automotive and Auto Parts Group (APG), GUD Holdings manufactures and distributes aftermarket oil, air, and fuel filters, gaskets, brake rotors, brake pads, lighting and electrical components, and 4WD and trailering accessories. In the auto parts industry, economic moats generally stem from switching costs, intangible assets, cost advantages, and sometimes efficient scale. We do not believe GUD has carved a durable advantage in any area.

We estimate about a third of GUD Holdings' revenue is derived from its three largest customers; although not reported, we estimate these customers are the auto parts retailers and trade businesses owned by narrow moat-rated Bapcor, narrow-moat Genuine Parts Company, and no-moat Super Retail Group. Although GUD Holdings' customer concentration is high, this is not unique to GUD. We estimate the market is similarly indexed to this level, with these businesses dominating auto parts retailing and, with Bapcor in particular, commanding strong positions in trade. However, we believe the balance of pricing power ultimately lies with these large customers. The firm's sales are also geographically concentrated: Australia represents the vast majority of consolidated revenue.

Yarra Australian Smaller Companies: Pinnacle Investment Management PNI and Flight Centre Travel Group Ltd FLT

Yarra’s Australian Smaller Companies Fund earns a gold medalist rating. Since 2018, Yarra’s head of equities research, the highly experienced Katie Hudson, has been the linchpin behind this strategy, with the knowledgeable Michael Steele supporting as co-portfolio manager since July 2020.

The team adopts a long-term" through-the-cycle" mindset to exploit time-frame inefficiency in the small-cap market. Research focuses on comprehensive bottom-up company assessments to form validated insights that are differentiated from the market view. The duo’s judgment as to what constituents a quality, sustainable business is a critical element to success. This is combined with a risk-aware portfolio construction, balancing risk and reward to size positions accordingly across stocks that vary in style traits. The resulting 30-60 stock portfolio is style-neutral, aiming to be opportunistic with no obvious growth or value bias.

There are two stocks that sit equal at the top of Yarra’s Australian Small Companies Fund in terms of weighting – Pinnacle Investment Management and Flight Centre Travel Group Ltd.

What Morningstar equity analysts think about the shares

Pinnacle Investment Management PNI ★★★

  • Fund exposure: 4.33% (at 31 January 2024)
  • Benchmark: S&P/ASX Small Ordinaries TR AUD
  • Benchmark holding: 0.71%*
  • Moat: Narrow
  • Fair Value: $11 (current price $11.38*) We consider PNI trading within a range we consider fairly valued
  • Investment style: Mid core
  • Sector: Financial Services

Pinnacle Investment Management provides seed and working capital, marketing and distribution services, business support and responsible entity services to a network of boutique managers--which it terms as "affiliates." Apart from charging fees for its services, Pinnacle also earns a share of profits from its affiliates via holding equity interests in them. As of December 2023, Pinnacle has 15 affiliates under its network with around $100 billion in funds under management (FUM).

Pinnacle typically caters to smaller-scale boutiques that lack the capital, investment infrastructure, and distribution capabilities of larger firms. Affiliates get to access new money from a growing network of investors (including retail and international clients), receive support on product enhancements (for example, help to create active ETFs, offshore vehicles like UCITS, or performance fee-based funds) and outsource back-office tasks.

The firm is also actively diversifying its asset class offerings and client base. Pinnacle is seeking to work with boutiques that manage non-traditional, in-demand strategies such as private capital, absolute returns, credit and ESG. Its client cohort is also expanding, with the proportion of revenue contribution from super and pension funds generally falling with time. Early-stage affiliates are typically put to invest for institutional investors, before they build a credible track record and are ready to accept retail money. More established affiliates may skip the development stage and sell to a wider audience from the start.

The outlook for earnings is positive as Pinnacle is essentially an incubator for growth. Inflows from new clients, product enhancements, and boutique additions all present opportunities for earnings upside.

Pinnacle possesses a narrow economic moat based on the intangible asset of its brand and switching costs. These sources of competitive advantage help provide stability in and grow funds under management across various market conditions. This means that our analysts believe that Pinnacle will be able to maintain a sustainable competitive advantage for at least the next 10 years.

Flight Centre Travel Group LTD FLT ★★★

  • Fund exposure: 4.33% (at 31 January 2024)
  • Benchmark holding: 1.45%
  • Moat: None
  • Fair Value: $21 (current price $21.59*) We consider FLT trading within a range we consider fairly valued
  • Investment style: Mid growth
  • Sector: Consumer Cyclical

Flight Centre is one of the world's biggest travel agents, but it still generates substantial earnings in Australia and New Zealand. Unrivalled scale and brand strength in the domestic travel market has delivered buying power and pricing flexibility that resulted in high returns on capital. Flight Centre has a strong network of services that has driven solid end-user traffic and bookings over the past 20 years, but we do not believe this is sufficient to protect the company against online competitors over the next 10 years.

Because of the discretionary nature of travel and high levels of operating leverage, earnings can be very volatile. During the financial crisis, net profit after tax fell to $38 million in fiscal 2009 from $143 million in fiscal 2008.

Flight Centre's significant scale and extensive store network have made the firm a key distribution channel for travel suppliers and generated cost advantages that enable it to offer competitive prices. However, with the threat from online competitors increasing, we believe physical stores are likely to lose relevance in the longer term.

A wave of covid-19-induced damages has been inflicted on Flight Centre since March 2020. Restrictions on travel and border control, grounding of airline capacity, and strict lockdown measures on consumers created an unprecedented squeeze on the group. However, the measures to execute a drastic reduction in costs (cuts to store network/leases, staff, marketing), combined with the $697 million equity capital raising in April 2020 and the subsequent recovery in travel activities, have stabilised the no-moat-rated group. And recovery to prepandemic level of earnings is on track.

*at 11 March 2024