Past performance is a guide to the future; avoid index-hugging managers; and never buy a bad stock simply because it's cheap.

These are among the "lessons" that Chris Cuffe, one of Australia's most respected investors, shared with the Morningstar Individual Investor conference last week.

One of Australia’s most successful investment managers, Cuffe is a former chief executive of Colonial First State and Challenger Financial Services and now portfolio manager of the charitable trust, Third Link Growth Fund.

Cuffe boiled down his experience into a watchlist spanning performance, advice on when to pay fees, the active versus passive debate, and stock valuation.

Past performance is the best guide to future success

Investment product disclaimers typically say that “past performance is no guide to future performance” or something similar. But Cuffe says that is debatable. Past performance is extremely important and can be an accurate guide to the future, he says.

“When you are trying to assess a fund manager, there is not a lot which you can rely on that you can say is absolute fact,” says Cuffe.

“When I am looking at a fund manager, I want to see their past performance, over different time periods. I want to see how volatile that performance might be, and I want to see how that performance may line up with things they are saying in their published literature,” says Cuffe.

“But I really am interested in long-term performance. I will give a manager a minimum of three years before I become more interested in results. And if I think changes are required, it rarely happens before five years. Long-term performance is key.”

Don’t overpay for active management

When Cuffe is selecting an active manager for the Third Link Growth Fund, he makes sure they aren't hugging the benchmark, which is easier said than done.

“There are plenty of statistics to show that more than half of [active] fund managers, or more, really don’t come up with active results,” says Cuffe.

“So, if you are paying fees for active funds management, you are quite often getting a very benchmark-like performance, and no wonder passive investing has been growing in this country where the fees are a whole lot lower,” says Cuffe.

“It doesn’t necessarily mean it’s a great investment, but you pay for what you get rather than overpay.”

“I am looking for active fund managers who really want to be different. I want managers who are definitely active and I want them to prove to me that they are active and I have the patience as an investor to ride out the tougher periods.”

Chris Cuffe at the Morningstar Individual Investor Conference

'If you are paying fees for active funds management, you are quite often getting a very benchmark-like performance, and no wonder passive investing has been growing in this country where the fees are a whole lot lower': Chris Cuffe at the Morningstar Individual Investor Conference. 

Watch the level of funds under management

Cuffe says the level of assets that a fund manager controls is crucial—a large size can get in the way of performance and it is no coincidence that most of fund managers Cuffe appoints to manage the Third Link Growth Fund have performance fees, which enable them to remain smaller.

“There are barriers that you can come up against with certain sizes of funds. In managing active Australian equities, I think once a fund manager is around $4 billion to $5 billion in size … it just gets harder to manage and get into stocks and harder to get out of stocks, just because you’re a larger part of the market. In the smaller companies’ area, I am pretty shy on any manager that has $1 billion or more in that area,” says Cuffe.

“But there are other asset classes where size is your friend, such as fixed interest,” and global equities.

Don’t be afraid of performance fees

Cuffe says performance fees are not a bad thing—as long as a fund manager is delivering active management and returns.

“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 per cent performance fee (as long as the right hurdle exists) if I’m getting 80 per cent.

“But most managers with a performance fee structure also charge a management fee as well, so it does beg the question, what is the management fee of an active fund for? If all you got was the index, then you haven't got a very good result for your management fee.

“Yet if the fund then outperforms the index, the performance fee kicks in, so it doesn't make sense ... You need to look very carefully at what are the hurdles [before the performance fee kicks in]. Funds have to be earning it, rather than gouging.

“The couple of funds I invest with, which are terrific funds, only have a performance fee, they have no management fee. If they don’t perform, they don’t get paid.”

Active versus passive depends on the asset class

The active versus passive debate should be considered in the context of the asset class and the components of an index. In Australian equities, Cuffe recommends active management given the concentration risk of investing in banks and miners. “Active investment management is a good place to be, particularly for small caps,” says Cuffe.

An index strategy is “a highly risky strategy because 40 per cent of the market is the top 10 stocks and 55 per cent is in the top 20 stocks, in a bunch of banks, a couple of miners and CSL,” which leads to concentration risk.

“But in the fixed interest area, you can have a passive portfolio, because fixed interest is completely different characteristics and it’s more about the credit risk and you just want [exposure to] a lot of securities ...  In international equity fund, I’m quite relaxed about having a fund that is more passive because it’s a much broader investment universe.”

Never buy a bad stock because the price is low

Cuffe warns against “deep value” investing, a strategy whereby a manager is willing to buy a poor quality stock because the price is so cheap.

“Deep value investing in my experience over time is that while it looks appealing, very few managers actually succeed in it. While the stock looks cheap, it looks cheap compared to what? Often the stock is cheap for a reason, not just because it has fallen out of favour. If there is something wrong with that stock, then it probably deserves to be cheap,” says Cuffe.

“You can easily buy the stock, but when you want to get out of it and things aren’t running in your favour, then it can be very hard to get out of these small stocks.”

Gearing isn’t necessarily good

While interest rates are very low, taking on more debt to buy equities isn’t necessarily a good thing says Cuffe. Interest rates can rise at any time, and borrowers can be caught short and unable to service their debts.

“Interest rates might be low, but equity markets might stay static for a decade, who knows? They have been valued so highly for the last couple of years, you wonder how much more we have got to go. It just adds a stress to investing that I don’t believe everybody needs.”

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See also Morningstar Guide to International Investing