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My 10 biggest investment management lessons

Editor’s introduction. There are valuable lessons to learn from Chris Cuffe’s experience with the Third Link Growth Fund. The Fund’s managers are selected by Chris in a ‘fund of funds’ structure, and all fees paid by investors go to charities. In addition, he sits on the boards of several Listed Investment Companies and is an adviser to family offices.

This is a selected Classic Article first published in 2015, with some changes to bring it up-to-date.

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After decades of managing investments and selecting funds, here are my 10 biggest lessons.

1. Most financial services are sold not bought

In commerce generally, the consumer finds the best products in the market, especially with such an open system as the internet. But financial services is an industry where products are sold not bought. There are a lot of middle men and women doing the selling. People struggle to find the best products in the world of investing.

If a fund does not have active sellers and marketers, it doesn’t get much support. Listed Investment Companies (LICs) have broker networks that work their clients intensely in the offer period, while dealer groups have advisers who tell their clients where to invest.

We’re not really long into the post-FOFA environment where financial advisers are no longer paid commissions by product manufacturers, but I don’t think advisers scour the earth looking for the best products. They have to do the right thing by their clients, but that does not mean finding the very best. It’s more what’s on their radar screens.

2. Joe Average doesn’t have a clue where to invest

In financial services, with most aspects of investing, Joe Average does not have a clue where to start to find the best products. To DIY in financial services is tough for the average person. I can DIY in my back yard by going to the hardware store, working out how to pave a path or tile a wall, but you can’t do that easily in financial services.

3. Don't pay active fees for index management

It’s astounding in Australia the number of managers who won’t risk being too different from the index. If they underperform for a short period due to departure from the index, they worry they will lose funds (and maybe their job will go as well). If resources and banks are not doing well, a fund with managers that are index unaware should do well.

I listened to an active Australian equity manager tell me how proud he was of being index-unaware, yet his exposure to financials was 27%, not the 30% per the index. This is not an active position at all and he is surely being driven by the index. I would think that a position of half or double or nil is more like an active view.

The best investors I deal with are totally benchmark unaware, even as to what markets they invest into, local or overseas or cash or whatever.

4. Blending styles is a waste of effort

In my view, professionals blend managers in multi manager funds in exactly the way that gives a mediocre result. Typically, they will blend value managers, growth managers, large managers, small managers, etc and then wonder why they achieve the index less their fee. The results of these blended funds have never been great.

I am not the slightest bit interested in blending styles and so some people are put off Third Link because there is no formal scientific process. My process is called experience – one of finding competent, proven managers who will swing the bat and have a go. I do watch for concentration risk but I’m mainly interested in the willingness of managers to pick stocks ignoring the index. In fact, I like to see a high tracking error which is the opposite of most professionals.

5. Past performance is the best guide to future success

Every offer document in the country says something like ‘Past performance is no guide to future performance’ or similar. That is exactly the opposite of how I think. It’s the best guide to knowing what a manager is really like over a long period. Past performance is extremely important and a great guide to the future.

Only long-term results are relevant. The managers I use are selected for the long term. I have no interest in their short-term results. If it looks like a manager is struggling (which I would only conclude after rolling three-year periods), I would only exit after say a poor rolling five-year result.

6. Never buy a bad stock because the price is low

I don’t like ‘deep value’ investing where a manager is willing to buy a poor quality stock because the price is so cheap. I don’t like people saying a bad stock priced cheap is low risk. I would hate to see any of the stocks held by my managers fall over.

Managers need to buy quality stocks. Adding that to a good track record and a high tracking error should mean my fund will do well in falling markets (which it does) which is a sign of a good portfolio.

7. Watch the level of funds under management

I do look at total funds under management in a manager and the types of stocks the manager buys. A small cap manager in Australia with more than $1 billion concerns me. And I am cautious about investing with a larger cap manager in Australian equities with more than say $6 billion under management. At that level, I need more convincing. It's less of a problem for a global large cap manager operating in a massive universe of stocks.

Size can get in the way of performance. It’s no coincidence that most of my managers have performance fees, which enable them to remain smaller while making it economically viable to run their business.

Most managers talk about staying below capacity and refusing to take in more money but my experience is most don’t do that, especially when there’s an institutional owner. It’s compelling to take more money. Boutiques are best at watching capacity as they can make a lot of money from performance fees if they are good.

8. Don’t be afraid of performance fees

I believe managers deserve their high fees based on their performance. In my own personal investment portfolio, I don’t care about paying a 20% performance fee (as long as the right hurdle exists) if I’m getting 80%.

It’s a great part of the Third Link structure that the managers kindly refund all the performance fees, as well as the management fees. It’s the sizzle in the Fund. For most professionals who provide a fund-of-fund product, the underlying fee of each manager is so crucial for their own economics that they cannot pay performance fees. But I’m agnostic to fees so I just look for the best managers.

I have not selected any of the managers based on their willingness to forgo their fees. I select on merit then ask if they will waive their fees.

9. Active versus passive depends on the asset class

The active versus passive debate is not a one-size-fits-all. It should be considered in the context of the asset class. In Australian equities, I’d never invest in a passive fund. You have to look at the index before you go passive. Why would you buy an index which is 30% in banks (mainly four stocks) and 15% in resources (mainly two companies)? Talk about a risky portfolio! It amazes me people would start with that. But internationally, say the MSCI World Index, index investing has merit. In Aussie small caps, you could invest in an index fund but I think there is no upside in having small resources because of their boom and bust track record. And I think the active managers of small cap industrials generally do better than the industrials index because they can find small under-researched stocks. But there’s nothing wrong with indexing in parts of the fixed interest asset class.

I hope some of the roboadvice models use active management, especially in Australian equities, but I suspect they are unlikely to do so due to the cost.

10. Business risk guides a lot of investing

The lack of willingness to be different from a benchmark has a lot to answer for in encouraging mediocre investing across the world. The dominance of these behaviours is far greater than anyone will admit. It drives many professionals to bizarre investing.

I don’t have any business risk or career risk in selecting my managers. Third Link is not a business and I’m running only one fund.

 

Chris Cuffe has a wide portfolio of interests across commercial, social and charitable sectors. More details on the Third Link Growth Fund are on www.thirdlink.com.au. How can we have a disclaimer after such firm opinions? Let’s just say anyone should seek professional advice on how these lessons apply to them, as the circumstances for each investor are unique.

 

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