Pick of the bunch: David Thornton on best managed funds

Picking the promising stocks, rather than following an index, is paying off for small-cap managers

Actively managed funds are facing stiff competition from passive exchange traded funds (ETFs), with the latter consistently outperforming the former. But that doesn’t mean that actively managed funds can’t outperform. So, what sets apart the funds that do generate returns consistently above the market?

Fund managers and their critics consistently measure performance against benchmark indices, but getting overly caught up in performance relative to an index might be what holds many fundies back from achieving consistent outperformance.

Australian Ethical and Cyan Investment Management are two small-cap fund managers that consistently outperform the index.

Australian Ethical’s emerging companies fund has averaged a return of 19.5%pa since inception compared with the S&P/ASX Small Ordinaries Industrials index’s 10.9%, while Cyan’s C3G fund has returned 15.4%pa since inception compared with the Small Industrials’ 9.6% over the same period.

But in terms of how they invest, the index means very little. “We’re completely benchmark unaware,” says David Macri, Australian Ethical’s chief investment officer. “And that’s genuine. Because of our ethical guidelines, we have to be different to the market.”

Instead, Australian Ethical focuses on stock picking, not trying to replicate an index. “We think these companies have a competitive advantage – they’re undervalued, so we’ll hold a position.”

Graeme Carson, a director and portfolio manager at Cyan, has much the same mantra. “We don’t benchmark against an index because that’s not how we think. We’re bottom up – we want to find businesses that are growing or about to reach an inflection point to clear growth.”

Up close and personal

Investing in companies at the smaller end of the capitalisation spectrum poses a range of opportunities and challenges.

Carson takes a more holistic approach to picking companies, based on a broader understanding of the business model and the people who execute it. “You need to meet the business, meet the management, have a holistic view of the numbers now and find out what they can look like if all the other pieces of the puzzle fall into place,” he says.

After that, Cyan looks at the financials, in particular: the return on investment capital.

“Yield means that the profits are getting paid out rather than reinvested in the company”

This means dividend-paying companies are out of the question. “People want to chase yields because they think yields are good, but we don’t think they are,” says Carson. “Yield means that the profits are getting paid out rather than reinvested back into the company to grow it.”

It comes back to getting to know the business and the management to then be comfortable that they are going to reinvest the capital in a prudent way. “If they do that, the valuation is going to grow much more than a company paying out dividends.”

Only once all qualitative and quantitative aspects of the company are understood does Cyan then pull out the wallet. “We figure out if we like their strategy, whether they can execute, what their competitive position is, what the financial position is like, and then if we’re comfortable with all that, it comes down to the price.”

Big returns in small caps

Small caps are often viewed as a riskier investment because of “information risk”. Because they’re newly listed, or soon to list, they don’t have the research coverage as bigger-cap companies, like the miners or banks.

“People say it’s risky, but if you filter out the things you view as risks, then we believe it’s easier,” says Carson. “At the smaller end of the market you can’t rely on quantitative analysis or broker research. And the numbers often don’t reflect the position the company is currently in.”

The adage that past performance cannot predict future performance rings especially true here – first, because there isn’t a lot of past performance to go by and, second, because young companies function in a way that is often very different from how they function when they’re much bigger.

That puts the onus on understanding the qualitative factors, namely getting to know the management.

“We have a head start over retail investors because we get to meet companies,” says Carson. “Company management will give you time, which is access you just don’t get at the bigger end.”

Access to management can also be an advantage, says Carson, because even if he doesn’t end up investing in a company, he may walk away with a nugget of information about the sector or a competitor.

“It’s hard to understand how bigger companies operate, the accounts are very complex and corporate governance is such that you often get fed a company line.”

If done correctly, small-cap companies can outperform their bigger-cap peers as they embark on growth, ideally through investor money that’s put back into the business.

“If they’re successful, the value of capital flowing through the business in the future will far outweigh the initial investment,” says Carson.

Ethical factors

Environmental, social and (corporate) governance (ESG) investing is going from strength to strength, no matter which way you look at it.

An ISS Market Intelligence report found that 55% of responsible funds outperformed the average return achieved across the combined responsible and non responsible market within their asset class over 2020.

What’s more, 80% of funds outperformed the market based on three-year compound annual growth rate, while 76% and 70% of funds outperformed the market based on five-year and 10-year CAGR respectively.

This outperformance was both domestic and global. The Australian equity asset class showed collective outperformance through the year, with 88% of responsible funds outperforming the market with an average return of 6.4% above the benchmark.

Responsible international equities funds have been long-term performers. Over the past three years more than 79% of these funds outperformed the market by an average of 3.1%.

As the name suggests, ethical investing is the heart and soul of Australian Ethical’s investment process. “Whether a company or sector is in our investible

universe depends on whether it passes our ethical charter,” says Macri. And most don’t pass. The ethical filters screen out about 60% of the market. “If they pass that, they’re in our investible universe.”

That investible universe is by nature a new-economy universe, dominated by healthcare, technology and renewable energy. Off the table are sectors such as iron ore mining, consumer staples and consumer discretionary.

Australian Ethical also filters within sectors. Take mining, for instance. While iron ore is out of the question, it can invest in lithium mining due to the role it plays in renewable energy, provided the company actively manages its social and environmental impact.

All told, the companies that are left envisage the kind of world you’d want to leave to your grandkids.

This vision tends to lead to higher performance. “It leaves an investible universe that is forward looking, which tends to be more growth-focused than what’s left behind,” says Macri.

A forward-looking investible universe is, by virtue of the nature of progress, generally higher performing than companies that make up the so-called old economy. “The areas we’ve focused in have benefited, such as tech and healthcare.”

While this may give Australian Ethical a leg-up when it comes to performance, it still then has to do its financial due diligence to find high performers. Just because a company is ethically or environmentally healthy doesn’t by default mean that the returns will be equally healthy.

“I look at how well we’ve done within our ethical investing universe,” says Macri. “We’ve managed to outperform in good-performing sectors. But I don’t agree that a company that passes our screen will by default perform better.”

Keeping cash to invest

An underappreciated aspect of actively managed funds is the amount of cash they keep on hand, rather than having it invested.

At first, it might seem that is a wasted opportunity. After all, money that isn’t invested can’t make a return, at least beyond bank interest.

But there are reasons why a fund may hold cash, such as to meet shareholders’ redemption needs, pay management fees or, if it’s an income fund, to distribute yield to investors. Holding cash can also be a way to protect capital when the market turns sour.

But Australian Ethical and Cyan hold it for another reason – to respond to market opportunities. “If we have a portfolio of companies and we sell out of one of them, we won’t automatically put that money towards other investments,” says Cyan’s Carson. “At times we’ll have 30% cash and at other times we might have 10% cash.”

Instead, Cyan holds cash as a bullet in the chamber to invest when opportunities arise without the need to sell out of other investments.

What it did during the pandemic is a case in point. “Going into Covid, we had about 30% cash and we put that capital to work over a three-month period, which brought us down to 10% cash,” says Carson. “We saw fundamental value as all stocks fell, and luckily we had some cash on the sidelines to put to work.”

Australian Ethical holds cash for the same reason. “The Aussie shares fund has historically held 5%-10% cash, but that’s more because we like to be opportunistic,” echoes Macri. “We don’t want to hold that up just because we don’t have the cash.”

While Australian Ethical and Cyan have consistently provided their investors with above-market returns, there are other models that work too.

What is clear, however, is that choosing a fund manager should take much more than deciding whether you like the companies in which they invest. Nor is it simply about looking at the three-month return and nothing else. It’s about understanding the path they take to get to those returns.

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