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The Performance Conundrum

28th March 2024

As fund selectors there are few things that get us more excited than finding a talented manager that few others have ever heard of (yes, we are that sad). Unlike some, we don’t need to see a three-year track record or minimum fund size to invest. The only pre-requisite for our support being genuine skill, cultural alignment, a truly active approach and an unwavering prioritisation of performance over asset gathering. These under the radar funds tend by definition to be small, imbuing the manager with a distinct competitive advantage when it comes to alpha generation. Indeed, both logic and the empirical evidence suggest that the bigger a fund gets the more unwieldy it becomes to manage. Entering and exiting individual positions without moving share prices becomes harder whilst the ability to play in the smaller end of the market where the greatest inefficiencies are often to be found becomes constrained.

Talented, conviction managers with the structural advantage of nimbleness at their disposal often generate the strongest returns which is where the potential problems begin. Unfortunately, we operate in a performance chasing culture where many fund buyers want to see consistent 1st quartile returns over multiple timeframes before investing (this is often the worst time to buy a fund in our view but that’s a subject for another day). In short, good performance can result in attention, flows and AUM growth which if left unchecked can slowly diminish the competitive advantage our fund manager once enjoyed. When backing a small fund we always ask about anticipated capacity and check that the fund is being managed in a way that is scalable in line with that ambition. Too often, however, as assets grow, capacity also magically increases, or the manager tweaks the process to include, for example, a longer tail of stocks or a lower allocation to small caps. Firm culture and incentive structures are important in assessing the extent to which fund management firms allow this drift to occur. This probably explains why we are often drawn to manager owned boutiques, where the PM has significant savings invested in the funds, there are no pesky corporate shareholders to appease, and where performance and reputation are given primacy.

Even in cases where we have confidence that the sanctity of the process will be prioritised over commercial considerations, the link between performance and asset growth means our interaction with a fund often has a certain lifecycle. We have, for example, seeded funds in the past with (at the time) relatively unknown fund managers who have gone onto become multi-billion behemoths appearing on every wealth manager buy-list in the kingdom. By that point we had long departed and moved on, recycling capital back into smaller more nimble funds. Identifying skilful managers is impossible to do quantitatively so requires shoe leather, lots of research meetings and lots of stone turning. The performance conundrum is a live one for us at the moment with a couple of relatively new funds we have backed in the last couple of years delivering stellar index-busting returns but also significant asset growth.

Which brings us to a rhetorical question over whether the environment for identifying talented fund managers operating within organisations that enhance the probability of investing success is as conducive as it once was? The past year or so has seen a number of boutiques shut their doors for good and a few others merge, reflecting perhaps the higher cost of doing business as well as a consolidated wealth management sector and its need for ever bigger funds.  Changing market structure and the rise of passive investing also plays its part, resulting in an environment where it takes longer for fundamental value to be recognised. This also comes at a time when the unrelenting focus on cost means tolerance for active fund underperformance is in shorter supply than it’s ever been.

Despite a difficult period in which a small cohort of mega-cap growth stocks have had a crowding out effect, we still think that active funds have a role to play. We also still believe that active is done best when the manager operates with as few constraints as possible, whether that be in terms of pressure to grow assets or pressure to beat a benchmark. For our part, we will continue doing the hard yards, keep turning over the stones and keep backing skilful managers at the helm of nimble funds as and when we find them.

Ben Mackie – Senior Fund Manager

For professional advisers only. This article is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. FPC24100.

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