It is usually a list of companies, derived from historic data, like historic share price growth and shares in issue. And such companies have often done well to get into the index, which indicates that they may be popular investments too.
Would you be comfortable if your active manager’s investment strategy was to own those companies that are the largest, whose share prices have increased significantly and are commonly held by their peers?
Why not just own cheaper passives? We are backers of passives, but it seems irrational for genuine, active investors to seek comfort in the index, when they are charging high active fees.
Indices are also backward-looking, at odds with active managers that seek tomorrow’s winners.
And to enhance their odds of uncovering a future gem, because competition for them is so fierce, active managers should be willing to look where the number of buyers and sellers is smaller, in less popular pockets of the market.
This is where it is rational to take liquidity risk, which should offer astute fund managers a real edge.
Principle three: We should be adding to investments when they go down, rather than when they increase.
In theory, this should apply to our fund choices. We should gain in conviction the more a fund drops in price.
We seek discounts when buying cars, houses and televisions, so why not funds?
Fund selection is an exercise in probabilities, where sample sizes need to be broad in order to see whether investors can gain from backing active fund managers.
A sample size of one or two proves very little, although we fully appreciate that some clients may well have allocated all their spare capital to Mr Woodford.
But as fund researchers, we need to look across the widest possible opportunity sets to see patterns and empirical evidence that can help guide us prospectively.
This data tells us that, rationally, backing many experienced, proven managers who invest differently to the consensus and who are struggling in the near term with performance should be sensible.
Our hope is that, once the dust settles on the Woodford issue, that investors remain committed to these principles.
Rory Maguire is managing director of Fundhouse
