We have talked about the benefits of transparency many times. Our full holdings database for ‘plain vanilla’ investment trusts has grown over the last couple of years, so we have started to provide the same analytics for these trusts as those already available for open-end funds. We wrote about this in early September. Now we can look at how style analysis on investment trusts can help to understand them better.
The starting point is Morningstar’s Style box. This is a nine-square grid that provides a graphic representation of the investment style of a portfolio. We classify securities according to their market capitalization (the vertical axis) and growth and value factors (the horizontal axis); portfolios with a mixture of growth and value stocks are represented by the blend segment of the Style box.
Morningstar determines the investment style of each individual stock in its database, according to a number of key financial datapoints, so as long we know what a fund holds, through disclosure of its full holdings, we can track its overall style for every portfolio that it releases—be that as frequent as daily or as infrequent as annual.
Why this is so important?
Let’s look at an example.
Aberforth Smaller Companies Trust (ASL) is a UK smaller-companies fund that carries a Morningstar Analyst Rating of Silver. Although the fund has performed well over its life in aggregate since launch in 1990, its returns between 2007- 2011 were lacklustre compared with its average Morningstar UK small-cap equity category peer and Numis Smaller Companies ex-IC benchmark, and the team wasn’t producing the level of outperformance we’d seen in prior years. Did that mean the process was broken, or was there some style drift creeping in? The answer is no and we can see this through their holdings-based style trail.
They have always followed the same, value investing approach and sought companies whose shares are priced at less than their intrinsic value. Such anomalies arise as a result of market inefficiency, which Aberforth believes is a particular feature of the UK small-cap universe. They have proven over time that this approach can work, but between 2007 and 2011, growth was simply more in vogue than value, and investors were shunning risk. This pattern can be seen when comparing the MSCI Europe Small Value index against MSCI Europe Small Growth. Indeed value lagged growth between 2007 and 2011 and then bounced back in 2012; thus, the fund's under- or over-performance has been determined not only by the team's stock picking skills, but the style being in- or out- of favour. In fact, there was a double-whammy effect because not only was value out of favour against growth, but also small-cap was out of favour against large-caps.
As part of our qualitative fund research process, we try to understand a fund's performance and whether it behaves as we’d expect, given the process that’s in use by the manager or team. Underperformance is never easy to stomach, but investors can retain conviction if managers stay true to their stated approach. Alarm bells should ring, though, if a manager is performing very well, at a time when his or her style of investing is out of favour, as that suggests they could be doing something different. Armed with that knowledge, investors can better understand the way each fund should behave in their portfolios. It’s just one of the reasons we believe transparency is fundamental for better decision-making.
