Fund manager skills first priority in concentrated funds, says S&P

The right fund manager with a good skill set should be the priority before the concentration of a fund is considered, according to recent Standard & Poor’s (S&P) commentary on concentrated Australian equity funds.

The conventional wisdom is that concentrated funds with a limited number of stocks will provide better returns for investors because they are more ‘active’, S&P stated. However, this approach also increases the chances of underperformance in a market downturn, and S&P noted that industry research into the characteristics of the concentration is not yet well developed.

“Conventional methods for estimating concentration include assessing the weights of a portfolio’s top 10 holdings or simply counting the total number of holdings. S&P uses a more effective approach, using the weights of all securities in a portfolio, to produce its findings,” S&P fund analyst Justine Gorman stated in her report.

S&P assessed the performance and investment characteristics of 11 concentrated Australian equity large-cap strategies, and highlighted issues that advisers should take into consideration before recommending investments.

“In S&P’s opinion, selecting a fund purely because it is concentrated will potentially result in no improvement in aggregate performance, and could impair risk-adjusted returns,” Gorman stated. “Selecting the most appropriate manager should be the correct approach. Only after this decision has been made should the amount of concentration come under review.”

She said given the concentrated nature of these funds, suitable investors are those with a willingness and ability to tolerate some periods of underperformance.

“Investors are leveraging the stock-picking skill and experience of the chosen fund management team,” she added. “It is therefore vital that advisers remain comfortable with the key decision makers involved in the management of these funds, and take appropriate and timely action if confidence in their ability to manage the fund in the future is lost.”

But Gorman said managers of concentrated funds have “developed a familiarity far above that of an average investor” in that they keep tabs of fewer companies and have the time to gain a competitive insight.

She said concentrated funds can prove to be a good investment due to: the potential for capital growth; after-tax returns; lower trading costs due to a lower portfolio turnover and more flexible stock; and sector limits allowing the manager to only hold what they believe to be the best stocks. She added that concentrated funds can also benefit from an absolute return-focused approach to preserve capital, and they are not limited to a specific investment style.