Investment Thinking – Q3 2020
08th October 2020
Thank you for your patience
08th October 2020
Introduction: Investment Thinking.
By Amir Miah – Junior Portfolio Manager and Nicholas Todd – Investment Analyst.
If there are any key takeaways from this note, we both hope that the reader walks away more aware of the benefits of genuine active investing in liquid markets, and inspire thinking on how one could take advantage of the extraordinary growth we hope to see a number of businesses achieve globally over the next 5, 10, 15 years.
The rise of passive investment products over the past couple of decades has led to the topic of passive investing becoming a prominent feature of the asset management industry. The intention here is not to get drawn into the active vs. passive debate; both styles clearly have their merits. Rather, some notes on passive investing have been included to bring into context our preference for genuine active investing when investing for clients.
At Binary Capital, we are not active in the conventional sense; seeking to trade in and out of tactical positions and attempting to time the market. In fact, we ‘actively’ avoid such short-term investment strategies. Several academic and professional studies have highlighted the detrimental impacts such strategies can have on the value of a portfolio. The daily volatility and noise surrounding financial markets is something we are not concerned with. It is onerous to keep up with and not the best use of our time as it detracts our minds from what is important; analysing and understanding funds, companies, and the longer-term themes and trends that will drive growth and value creation. We are founded on a high conviction, active, but patient, long–term investment management philosophy and therefore we will try to focus on the merits of such a genuine active investment strategy here.
Passive investing does the job
The expansion of passive investment strategies and explosive growth in the number of Exchange Traded Funds (ETFs) and index funds available over the last decade, has provided a generation of investors with the opportunity to simply mimic an index or a benchmarks performance to gain double digit returns without having any strong investment views.1 Furthermore, passive smart beta investments provide a means for investors to gain accessible packaged exposure to sectors, themes, or factors, replicating much of the alpha that active long only mutual funds and hedge funds have traditionally offered.
Passive investing is built on the foundation of Eugene Fama’s Efficient Market Hypothesis; if markets are truly efficient then current market prices will contain all relevant information. As a result, this limits the opportunities for active investors to ‘beat the market’, and in turn propose one is always better off mimicking it instead. It is this idea that has driven billions of dollars into low cost benchmarks that aim to replicate the performance of the market basis point by basis point. Typically, investors will do this by buying an ETF or index fund that aims to track the index by buying all the stocks that represent it.
As an example of ETFs continued popularity, in August 2020 the popular Invesco QQQ Series 1 Fund (NASDAQ 100 tracker) received inflows of $2.4 billion and has achieved a total return YTD of 35%.2 We ask, what if the aim was not to find short-term arbitrage or mispricing in asset prices, but to participate in the extraordinary growth of exceptional companies over a long-term horizon such as 10 years and beyond – does that provide us with an opportunity to beat markets?
Under the index tracking passive model, shares of companies with large weightings in the major indices attract more capital regardless of their fundamental performance and can therefore create mispricing relative to a company’s future prospects. We would not ordinarily imagine investing our client’s capital into declining sectors such as oil and gas, big banks or high street retail at this time, as this will only cause unnecessary value destruction in our clients’ portfolios.
Active fund management; a broad universe of non-homogenous fund strategies across all asset classes. Our focus at Binary Capital is on long-only mutual funds and investment trusts. Are active managers truly active and value for money? This is a question that is often asked by clients, requiring justification for higher fees. The pressure of being fired for underperforming benchmarks and cost competition within the industry has resulted in many managers shying away from building what we see as genuine active portfolios – portfolios characterised by high conviction and low turnover. Genuine active management requires managers to be brave and stick with their convictions as there will inevitably be periods of underperformance.
How can we find these brave managers? The widely used concept of ‘Active Share’ developed by Martijn Cremers and Antti Petajisto in 2007 can assist fund pickers when deciding how ‘active’ a fund is. The model determines the proportion of an equity funds holdings that deviate from a given benchmark; establishing which funds are genuinely active and those that are closet index trackers. The measurement is based on fund managers holding stocks not in the benchmark, omitting stocks that are in the benchmark or invested in securities that make up the benchmark but are allocated different weights.3
A recent study by Invesco applied this concept to analyse the outperformance of active fund managers across a range of 5 market cycles based on the S&P 500. They found the following: Active management excess returns over the time period and across several business cycles outperformed passive benchmarks, with 61 percent of funds deemed to have active share beating their benchmarks (gross of fees) across all market cycles. Furthermore, for risk-adjusted returns, once again, 61 percent of high active share fund assets generated more return per unit of risk than their benchmarks.4 Nonetheless, we remain cautious about studies from product providers, and those that see active funds as a homogenous cluster. Being different from the benchmark will not necessarily mean outperformance by managers, it indicates managers that are willing to stand out from the crowd.
Our genuine active management approach
At Binary Capital we take a refreshingly transparent approach to investing from other wealth managers and discretionary fund managers, which can be seen from a glance at our portfolios. We aim to develop strategies that are different – whether that is through our use of investment trusts, being highly concentrated in our best ideas, or investing exclusively in long-only, long-term mindset mutual funds in our MPS ranges. Foundational to our thinking is to remain invested for the long term, based on our in-house macro view and on the themes and trends that we believe will continue to perform well. We are aware of benchmarks, but do not build our strategies around them (for complete transparency we show our performance against very competitive composite benchmarks – and we suggest the reader taking the time to understand our investable benchmarks for your own performance comparisons).
We believe active investing is about investing in the people, companies and generational shifts that underpin our reality. We are quality growth investors, looking towards the future – the past is the past and we cannot change that. What we can do is seek to participate in the future. Investing is about taking an active stake or ownership in exceptional companies and funds and to share in their success and growth. Our strategic asset allocation decisions are made on an annual basis but are continually monitored throughout the year. We prefer to remain patiently invested. We are conscious that the economic landscape can change dramatically in a short period of time – if changes need to be made, they will be made.
A focus of ours is ethical and ESG investing. Many ESG passive funds allocate through purely quantitative measures with a significant proportion of the data reporting poor at issuer level, low quality or estimated. We go further than this simple approach to help minimise the effects of ‘greenwashing.’ We see the oligopolistic nature of the passive fund market as damaging for governance standards and competitiveness within industries, with BlackRock, Vanguard, and State Street Global currently owning around 20 percent of US large-cap companies.5 This dominance results in smaller groups of active shareholders having less influence when voting takes place. Our ESG investment process enables us to capitalise on the long-term environmental and social trends using both qualitative and quantitative factors with equal importance to invest in funds that do the same.
Our qualitative analysis of the fund management team, their track record and investment philosophy are just as important to us as past performance, and we favour those fund managers that place a high importance on active ownership.
Whilst writing this short article our belief in our investment strategy and our philosophy that underpins all that we do – being long term, high conviction, never over complicating matters, investing only in our best ideas, became even more pronounced. It does not take a genius to understand that this style of investing can result in exceptional returns above passive benchmarks.
A passive investment strategy may be suitable for many investors but the ‘one size fits all’ approach is not for everyone. Many wealth managers want more for their investors. Many investors want more from their portfolios; the chance to earn exceptional returns from meaningful exposure to the best growth companies in the world (what is the value in holding 0.01% in an exceptional company?), and exposure to long-term trends and themes shaping our world – from the growing global influence of China to the novel technologies that we are adopting as a society. There is more to investing when we look away from beating the benchmark.
We expect to face some uncertainties in the short and the medium term along with much of the investment management industry. The effects of the pandemic and the dislocation between the economic environment and the financial markets continues to persist – how long will this last no one can be certain. We do not react to short term noise; we do not unnecessarily sell down positions in times of uncertainty; we are confident that our portfolios are composed of equities and bonds of high-quality durable companies that will continue grow and weather such storms.
By making an investment, your capital is at risk. The value of your investment depends on market fluctuations outside of our control and you may get back less than you invest. Past performance is no indicator of future performance.