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In the battle between passive and active investing, there has been one clear winner in the past decade. Passively managed index funds now account for a majority of assets under management in the ETF and mutual fund space.
The reason for passive investing’s triumph over the past decade has many contributing factors, but probably one core reason: the investing public has been convinced by the data that is it exceedingly difficult for any one portfolio manager to beat the index consistently and over longer periods of time. Even Warren Buffett has said that index fund funds are the best destination for the overwhelming majority of retail investors.
An added reason that passive investing has gained momentum is that the message of simplicity is likely to be favored by your average retail investor (a full time non-investment professional with a 401k and IRA as their primary investing vehicles, for example) who doesn’t have the time or inclination to research funds in detail and make choices of where their portfolio should tilt towards growth or value, or large or small-caps based on the current market environment.
As passive index investing is likely the most suitable option for this large audience of not particularly sophisticated investors, the personal finance media has largely amplified the message as its fiduciary duty and has left its old love affairs with active managers in the dust. In fact, the media seems to enjoy taking pot shots at hedge fund and active mutual fund managers far more than it likes to highlight their performance. The days of lauding the likes of Bill Miller, Bruce Berkowitz and Mario Gabelli are mostly over.
Actively Managed Funds: Why Bother?
Given this environment and that most people would be best served by a reasonable asset allocation constructed with low-cost index funds, why discuss actively managed funds at all?
We think there are a few reasons:
1) BroStocks readers like learning about active investing strategies and even if you choose not to invest with an active manager, you can learn from the individual calls that some of these leading portfolio managers make.
2) An actively managed fund can give you access to a differentiated and diversified strategy at a much lower entry point than you are capable of accessing or building yourself (most funds have a minimum investment requirement of $2,000, but some are as low as $250 to buy-in).
3) With the right active manager, you are leveraging their professional-grade research capabilities, market experience and relationships (such as the ability to meet directly with the executive teams they invest in—can you get a meeting with Elon Musk based on the five shares of TSLA you hold in your Robinhood account?). For some investors, handing off at least some portion of their investable assets to a professional manager whose process and style they trust makes sense.
4) Market forecasts from everyone from GMO to Vanguard, the premier passive investing index fund shop, all project lower index returns going forward than what we have experienced in the past ten years.
This is partly because indices tend to revert to the mean, and while recent years have provided above-average returns, eventually the longer-term return average is likely to prevail, which means the years of excess returns from 2009 – 2020, will need to be “paid back” with lower than average returns. Will passive index investing remain attractive if the index only returns 4% annually, instead of 14%?
5) Charts like this one:
As you can see, when you select the right actively managed fund, the results can be dramatically different compared to accepting the index (minus fee) return that passive investors implicitly accept when buying an index fund. Concerns about paying management fees seem to vanish when your total return vs. the index is nearly doubled over the course of a decade. If you had invested $10,000 with Akre the day the fund opened you would have more than $50,000 today, less than 11 years later.
If success leaves clues in life, is it also true of active fund management? Let’s take a closer look at the Akre Focus Fund (ticker: AKREX) and see what clues were on offer and that you can apply to your own active fund research. While the Akre Focus is certainly an outlier among the actively managed fund universe, it does hold lessons that may help you identity the next fund that has potential to outperform the market.
Case Study: Akre Focus Fund (AKREX)
Let’s consider some aspects of the Akre Focus Fund below and how these factors may have contributed to its strong outperformance compared to both the S&P 500 and other actively managed peer funds, the vast majority of which had nowhere near the success of Akre during this time period.
- Strong managerial track record based on a proven process
This first point is key and one that is often misunderstood by investors in active funds and those that totally dismiss such strategies. The most important aspect of selecting an actively managed mutual fund is to evaluate who exactly is running the fund. Think person, and not brand.
Many large fund shops like Fidelity and American Funds are well-known to investors but it is the individuals who actually run the specific funds that matter. When you research this aspect, you will often find that larger fund firms have a revolving door when it comes to portfolio managers. This means that the Fidelity fund’s track record you are viewing that looks great could have actually been built by a portfolio manager who left the fund last year and that its new steward is completely unproven.
On the other hand, passive index fund advocates will argue that even an individual fund manager’s track record can not be trusted as it is mostly down to luck or that manager’s style matching the current market environment. This misses the mark to us. While there is some element of luck to all investing, managers with long-term (10 year plus) track records that can demonstrate a clear process should be given some level of latitude as they have likely invested through at least one full market cycle and their results can be judged in both good and bad times. Remember, passive investing is not exactly entirely passive; it is arguably a style of momentum investing where positions are magnified or trimmed based on the growth of the stocks’ underlying market cap. While the decisions are made by preset rules, there is still an element of active investing involved even in the most passive index strategy.
In the case of Chuck Akre, the lead portfolio manager of the Akre Focus Fund, there were previous clues available as to the fact that he had a successful process and an established long-term track record.
That’s because before he launched the eponymous Akre fund, he was the lead manager of the FBR Focus Fund, which had a remarkable run of performance of its own, as described by MarketWatch at the time Akre was setting up the Akre Focus Fund in 2009:
Under his leadership, FBR Focus, with $1 billion in assets under management, has been one of the best-performing stock mutual funds. The fund has annualized returns of 13% since its inception in December 1996 — placing it 10th among all U.S. stock funds during that period, and second overall among mid-cap funds, according to industry tracker Morningstar Inc.
Akre’s FBR Focus has never trailed the Standard & Poor’s 500 Index in any rolling five-year period.
2. Distinct, focused portfolio
The name of the Akre Focus Fund gives this point away: focus. The portfolio holds around just 20 stocks. This makes it stand out compared to not only an index fund, which buys every stock in a given market, but also many other actively managed funds that are often accused of “closet indexing” or constructing portfolios to be so similar to the index to not provide much differentiation but still charging above average fees.
If you’re going to take the time to invest with an active manager, you want to align yourself with one who has high levels of conviction in their stocks and typically that will mean leaner portfolios with many fewer names than the index. Treat any actively managed portfolio with 100 + names with skepticism.
3. Willingness to make contrarian calls
A related point to managing a compact portfolio is that active managers need to develop perceptions at variance with the market consensus through contrarian calls. Having a limited portfolio won’t pay off if the top holdings are similar to the index.
One such call Akre made that paid off handsomely for investors was his buy of Moody’s Corporation (ticker: MCO) at the start of 2012.
You may not appreciate today how much of a contrarian call this was. However, at the start of 2012 investors were coming off a down year in the markets and many felt we were at the beginning of being sucked into a fresh bear market and economic decline following the Global Financial Crisis. Housing still hadn’t completely bottomed and unemployment remained stubbornly high, at more than 8%.
On top of it all, anger at Wall Street and the bond rating agencies such as Moody’s remained scorching hot. There was some speculation legislation such as Dodd-Frank would make the business models of credit rating agencies such as Moody’s less profitable or even not viable. In other words, this was a tough time to go long in this name.
When it came to Moody’s, however, Chuck Akre saw things differently:
Moody’s ratings business is exceptional, with proven pricing power, tremendous barriers to entry, high margins (operating margin averaged 46% from 2008 to 2012), and requires little investment capital to grow. Following the 2008 financial crisis, Moody’s was widely criticized for its role, for reasons both real and perceived. Investigations, litigation, and regulatory reviews ensued and Moody’s stock price plummeted. Our thesis deviates from popular perception in that we consider Moody’s global dominance and the oligopolic structure of the ratings industry to be the result of market forces, not regulation. We believe that those same market forces will see Moody’s through the post-crisis period with its “toll-bridge” status intact along with the potential for continued upward revaluation of the stock.Akre Focus Fund 2014 Portfolio Briefing, via GuruFocus
And how did this investment in Moody’s turn out for Akre and the investors of the Akre Focus Fund? A picture is worth a thousand words in this case:
Not only was this a great individual investment, but unlike an index fund with its set percentages based on market cap, Akre was able to scale into this position at his discretion, and has made MCO a significant percentage of the Akre Focus Fund portfolio. Today MCO is the fund’s third largest holding, comprising nearly 10% of the portfolio. A big win, that was magnified by managing a focused set of high-conviction names so that winners such as these made a noticeable impact on the bottom line.
4. Resilient top holdings
If you’re investing with an active manager who runs a focused portfolio, then you should have broad comfort with the fund’s top holdings, because it would be similar to if you were holding these names as individual stocks. In the case of Akre Focus Fund, beyond Moody’s, his top holdings have remained relatively consistent and steady: American Tower (AMT), MasterCard (MA) and Visa (V).
All four of these holdings (including Moody’s) operate as “toll-booth” business models where they provide the infrastructure and charge other entities for the continuous rights to use it. All of them also feature relatively wide moats: it’s awfully difficult to start a new merchant card payments infrastructure or national cell phone tower network from scratch in order to compete with these companies.
Before investing in an actively managed mutual fund, make sure you understand the portfolio manager’s thesis for his or her top holdings, which will have a disproportionate impact on your total returns vs. the benchmark.
5. Success not dependent on economic forecasting or certain macro conditions
An active manager running an energy sector fund can’t escape a crash in oil prices; no matter how skillful the manager’s process, that fund is going to lose money as the price of oil and with it, oil producing companies the fund invests in sell-off. Investors should avoid active managers who need a strong economy or rely on a certain macroeconomic forecast to come true.
Akre’s fund has performed well in both good years and bad.
During the fund’s launch near the bottoming for stocks but also through years of a persistently weak recovery, Akre was able to adapt his style to focus on stocks that benefit from a “constrained consumer” such as TJX Companies (TJX), Ross Stores (ROST) and Dollar Tree (DLTR).
(To read more about stocks that benefit in recessions check out our article on inferior goods here.)
This bet on the constrained consumer paid off spectacularly, delivering a remarkable return of more than 11% in 2011, which was a down year for the S&P 500 index. This ability to outperform the index return in any given year, such as Akre did by more than 13% in 2011, will always entice some portion of investors who want to do better than what the market gives them.
The key is making sure your dollars go to a true star fund manager like Akre who has a proven process, track record and fund construction and not one of the many, many suboptimal actively managed choices that charge high fees for underperformance.
Final Thoughts: Tools for Mutual Fund Research
Whether or not the Akre Focus Fund is right for you will come down to your personal investment goals and risk tolerance. What’s remarkable about Akre is that his outperformance of nearly 4% per year over the index return comes in an area (US large and mid-cap stocks) where academic research and data suggests it is most difficult for active managers to outperform. Generally speaking, you have a better chance of finding outperforming strategies in areas of the market that are less mainstream, liquid and niche such as emerging markets, small-caps or international real estate.
For those interested in researching actively managed strategies you can’t go wrong with Morningstar. The fund research service provides a lot of great detail for free and a subscription can be well-worth the price if you are interested in their analysis of both mutual funds, ETFs and individual stocks.
Another excellent (and free) resource is Mutual Fund Observer. This non-profit service provides in-depth monthly observations on specific actively managed fund strategies as well as the overall state and direction of the industry. The editor will call out shenanigans (of which there are plenty in this industry) while also highlighting the relatively few superlative offerings such as Akre Focus Fund when they are deserving of plaudits.
In summary: most active mutual funds fail to earn their fees and there is no guarantee that a previously successful mutual fund will continue to outperform the market just because it has done in the past. However, just because the majority of such funds fail, it shouldn’t deter you from doing your own research to identify one or two that have the potential to do a good deal better than their peers and even the index. We hope showing you the performance (and more importantly the attributes that likely contributed to such performance) of the Akre Focus Fund and its manager Chuck Akre, as illustrative of this point.
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