“Being an investment manager doesn’t require just our fiduciary stewardship of your assets invested with us. It also requires we provide you with the most relevant, timely, and useful information to understanding our methodology, purchases, sales, and performance. As an investment partner, we look to provide you with the same service we would look for if we were a customer. Partnership requires honest and fair dealing – with both the investment of your money and with information about your investments.”
- Nintai Investment “Statement of Investment Partnership”
When one considers performance of active versus passive (index) investing, many times you will hear about how some markets are great for indexing - like the last 10-year bull market[1]. Of course, those arguing that bull markets are great for indexing and make it difficult for active investors to outperform are - wait for it - active investment managers. Indeed, the last 10 years (through 2018) have been cruel years for both value and growth investors[2]. For Large Cap (Growth, Blend, and Value) investors, only 9.6% of funds survived and beat their respective index. It was slightly better for Mid-Cap investors (18.2%), and for Small-Cap investors (19.5%). The disparity between the highest and lowest funds was shocking. For instance, in the Large-Cap category 15.7% of the least expensive funds beat their proxy while only 5.3% of the most expensive funds beat the same proxy. For Mid-Caps, 24.1% of the least expensive funds outperformed their proxy while only 10.2% of the most expensive compiled such a record. For Small-Caps, 23.9% of the cheapest funds outperformed versus 12.6% for the most expensive.
No matter how you slice it, those are difficult numbers to absorb as an investor looking to fund their retirement or child’s college education. It’s not difficult to see why the last decade has seen a massive influx into index funds. Yet, even with these numbers over half of total investments in the United States are still in actively managed funds (roughly 52% active versus 48% passive in 2019 according to Morningstar).
It Isn’t Just Underperformance, But Also Under-Reporting
None of this information should be a great shock to investors (or fund managers), but sadly it is. As an active investment manager myself, I find not only outperformance is required to grow my asset base, but providing my investment partners with accurate, relevant data is essential as well. After considering this - along with the aforementioned performance data - I decided to investigate what type of information is provided to fund owners with a particular focus on the distinction between high- expense funds versus low-expense funds. After all, with such a larger group of high-expense funds underperforming, you would think they would have considerably more explaining to do.
I couldn’t have been more wrong. I divided quarterly reports into several major areas to see how each group does in terms of level of disclosure or discussion. These include investment strategy, portfolio holdings discussion, investment buy/sell criteria, and valuation of a holding at the time of purchase or sale. For the most expensive funds, a sample of 37 funds showed roughly 55% discussed their investment strategy while 45% did not. Roughly 35% did a cursory overview of portfolio holdings while 65% did not. Only 18% specifically discussed the business case for specific additions or sales to the portfolio. 82% made no mention. Finally, only 27% discussed valuations related to specific purchases or sales. The least expensive were considerably more forthcoming with data and discussions. A sample of 32 funds showed that 78% discussed their investment strategy. Nearly 60% discussed a percentage of their holdings (usually the top 10). A whopping 71% discussed specific purchases or sales (versus just 18%!). Only in the discussion of valuations related to purchase or sales were the two groups similar in percentage, with 34% of least-expensive funds discussing this subject.
So what should we make of this? Not only do funds with higher expenses underperform at an alarmingly higher rate than the least expensive funds, they also disclose far less in terms of portfolio specifics. Only in one area do high-expense funds out do low-expense funds – discussion of macro-economic issues. Presumably this is because they have less incentives to discuss performance and more to convince their investors why they are relevant.
What Needs To Be Discussed
In my mind, the more information I share with my investment partners the better. That doesn’t mean every one of my investors reads everything I provide. But overall, I think it should be the investor’s decision - not mine - to decide what is too much and what is enough. Over time, I’ve found the following four items give my investors the best chance at fully understanding my investment strategy and decisions surrounding their portfolio holdings.
Explanation of Investment Philosophy
Whether it is Berkshire Hathaway’s “Owner’s Manual” or Nintai Investment’s “Statement of Investment Partnership”, every quarterly and annual report should include a summary of the investment manager’s methodology. Even better, examples of this including recent purchases and sales in the portfolio should leave investors with a clear understanding of what and how the manager is looking to achieve long-term outperformance versus their respective proxy. I include Nintai’s “Statement” at the beginning of each annual report and include an example of a portfolio holding’s purchase or sale with an explanation of its relevance to my core strategy.
Investment Cases for New Investments
Each time I make a purchase or sale in any Nintai portfolio, I send each impacted investor (I may not necessarily purchase or sell a holding in all accounts) a detailed business case about the holding including a numbers-based summary (returns, free cash flow, debt, etc.), investment thesis, business overview, market characteristics, competitive analysis, business case risks, and valuation summary. In general this is 3-4 pages in length.
Valuation Methodology and Estimated Intrinsic Value
I also send a summary valuation spreadsheet that includes a free cash flow valuation worksheet and multiple tabs that include return on capital calculations, balance sheet strength, allocation of capital, cash return, rate of return, etc. This gives the investor a chance to roll up their sleeves (if they so choose) and better understand why I think the price of the asset offers an adequate margin of safety and how I derived an estimated intrinsic value.
Evaluation of Performance
The performance of Nintai Investment’s portfolio is front and center in each of my quarterly and annual reports. This includes both good and bad data (thankfully the good has far outweighed the bad, though past performance is no assurance of future returns!). I like to discuss those companies that added the most to returns and those that detracted the most. In the latter case, I find it helpful to outline how and where I got the investment case wrong and what steps can be taken to turn things around. This includes a frank discussion on what data points or results might require taking losses and moving on. I measure performance against both the S&P 500 TR (whch many see as a proxy for the market) as well as a individualized portfolio that best matches the portfolio but based on a collection of index funds and cash such as 15% Vanguard US Small Cap Index, 35% Vanguard Mid Cap Index, 35% Vanguard S&P 500 Index, and 15% Vanguard Short Term Government Bond Index.
Not every fund manager is going to be able to provide this to their investors. Funds with 1,200 holdings or 350% turnover are unlikely to be able to (or be financially capable of) providing such information on a quarterly basis. But when asked, they should be able to provide such data. It is their investors’ money after all for heaven’s sake.
Conclusions
Active investment managers haven’t done a very good job of demonstrating an ability to outperform their respective index. They’ve done an even greater disservice to their investment partners at reporting and discussing as little as possible about their methodology, process - and most importantly - their performance. If we are - as a collection of investment professionals - going to change the trend of investors moving to passive investments versus active management, then we not only need to better our performance, but do a better job communicating with our investment partners. Underperformance requires more communication, not less. While it doesn’t make underperformance any easier to take for investors, they will at least better understand how and why such underperformance is taking place and how managers intend to turn things around. It’s the least active manages can do to allay the fears of a rightfully frustrated investor base.
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[1] This is true in some ways but doesn’t tell the whole story. Many stock segments are performing quite poorly when compared to the S&P500 (the largest 500 companies publicly traded). For instance, Morningstar reports that nearly 25% of all publicly traded stocks are currently (as of April, 2019) trading in bear market territory. But overall, the last 10 years have been on average a tremendous bull market that has lifted the majority of all boats.
[2] Data for this section comes from Morningstar’s Active/Passive Barometer. Information is from the 2018 report published in March 2018. The authors are Ben Johnson CFA and Alex Bryan.
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