The recent scandal around celebrity fund manager Neil Woodford shows just how badly things can go wrong when questionable governance standards are met with lower levels of investor scrutiny. It all starts (and ends) with research. Everyone does it, but it simply doesn’t mean the same thing to everyone.
We never make an investment without having first screened, scored, ranked and filed it properly. Seeing the whites of the eyes of the managers we entrust with our client savings is a prerequisite, not a benefit of our size. Our approach to research is scientific, evidence based, asking pointed questions. We do our best to understand what we’re looking at before investing a penny. And then we ask more!
Keeping track of investments is as important as finding new ideas. We watch out for a wide range of risks: portfolios can get too concentrated, become increasingly illiquid, employ high leverage, be exposed to particular styles or factors, become unduly expensive, suffer from regulatory change and questionable governance, be exposed to environmental or social risks. Every year we conduct hundreds of meetings with managers and engage in thousands of emails and phone calls with investments in our client portfolios to make sure we’re up to date with what’s going on. We flag anything that looks unusual, which drives us to seek answers.
It’s a lot of effort. So why not just go passive? It’s easier, cheaper and certainly wouldn’t present the same governance problems we see from time to time in active fund management. The trouble is you only swap one set of risks for another. When the going is good, the risks matters less. But what happens when risk matters more? With passive investing, you are most likely investing proportionately to company size. That means more concentration in individual companies. If anything goes wrong with one of these larger companies, passives will be more exposed.
With bonds it often means investing more heavily in the debt of the most indebted companies, i.e. the ones most susceptible to defaulting on their obligations. Then there is the question of which passive fund to use. There are more than 50 of them tracking different parts of the UK equity market alone. They are available at low fees, but none of them offer any risk management.
There are a few signs warning of trouble ahead. It is in more troubled times that the benefits of active management, of putting the effort in, should bear fruit. After such a protracted bull market, people have forgotten what canaries look like, let alone why they’re in the coal mine.
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