Fundamental Tracking; the story so far.

Nearly four years ago a new investing concept was launched in the UK. The fact only £2.3m is managed using this technique might indicate that it has failed. However, analysis of the data suggests a different conclusion.

First it is worth understanding what fundamental tracking is, and what its ambitions are. The arguments in favour of passive investing are well rehearsed and well known. It is not so much that EMH works but that the time and effort to beat the index is not repaid by better risk adjusted returns. It argues that you can beat the market, but only by taking excessive risk that now and then turns round and wipe out all the gains. Worse, you never know in advance which particular strategy will be rewarded in the future. What is clear is that there is little persistency of styles from one year to the next. In short, active investing can work, but the time, effort and cost often absorbs all the gains at the gross level and leaves the investor little better off at the net level.
Until four years ago the only alternative was to use an index tracker that simply followed the constituents up and down. Its principal merit was low cost which instantly gave it a head start of 1% or more a year over its active peers. No one pretended it was a very clever solution but it had the merit of beating most of the opposition. There is though a fatal flaw in index funds and one that can only be resolved by making a Faustian pact with hedge funds. Allocating capital by price, as index funds do, means that there is an irresistible pull of money towards the most expensive shares.

The consequences of that were eloquently displayed in the millennium tech bubble when concept stocks popped in and out of indices depending on their popularity with no regard to their underlying profitability. If nothing else the tech bubble demonstrated the veracity of Ben Graham’s aphorism that in the short term the stock market is a voting machine. Anyone who has ever participated in an investment committee or joined an investment club will appreciate that democracy has drawbacks as a method for selecting shares. Essentially, an index fund represents the summation of all the opinions in the market about each and every stock and is a measure of its popularity.

While this is often a good guide to its prospects from time to time the market gets carried away with irrational exuberance and attributes unusually high values to certain stocks. Index funds then became a mechanism to attract even more capital to that stock creating a positive feedback loop that must eventually become unstable. Calling the top of any share is a mug’s game but once the decline starts it attracts the attention of the symbiotic partners of index funds; the hedge funds. They get involved because index funds lend out stock to generate additional income. Using borrowed stock hedge funds can then short those shares and exaggerate the decline. So we have a system that exaggerates the upside and the downside. Isn’t capitalism wonderful?

Surely it would make sense to design a system that allocates capital properly in the first place.
Such a system would eliminate the upward momentum caused by the popularity effect of allocating capital by price. In addition it would not need hedge funds to unwind excessive valuations and cause sharp downward volatility. Moreover, by having a frame of reference that is not related to share price it provides a device for actually taking advantage of volatility. If a share is deemed too highly priced a fund that looks at the fundamentals will only have a modest exposure to it, and will reduce its exposure the more expensive it gets. Similarly, a stock with sound long term prospects might be hit by bad news that could occupy a lot of column inches but does not materially affect the company. In November 2010 a Qantas jet had to make a forced landing because of the failure of a £RR.engine. The engine maker’s shares dropped sharply from 640p to 580p but have subsequently recovered to 640p. In hindsight that event provided an excellent opportunity to add more Rolls-Royce to a portfolio. A fundamental tracker can do that. A conventional market cap weighted fund simply follows the stock down and back up again without taking any action.

The second half of Ben Graham’s aphorism is that in the long term the stock market is a weighing machine and there is abundant evidence that it weighs dividends more than any other single factor. That is why The Munro Fund, the only fundamental tracker fund, uses dividends. Be clear on this, it uses dividends, not yield.
What this does is to give a clear guide on how much the fund should hold in each stock. Normally the differences between what the fund holds and what a conventional index tracker holds is not large. That provides confirmation that, by and large, the market is pretty good at allocating capital. There are though some stocks where the market gets unduly bullish or bearish and that is when a fundamental tracker adds value over an index fund.

And, after four years, the evidence is coming through that this is indeed the case. Over the last year the fund has lagged the index by0.3%. What is revealing about this statistic is that this is net of fees. While the fund has an AMC of only 0.5% its small size means that it labours under a TER of 1.6%. If the fund was a reasonable size, with a TER close to the AMC, it would have beaten the index. When measured over a shorter period the outperformance is more evident, 2% ahead over the last six months. Over three years the performance is behind that of the index again by the cumulative difference between the AMC and the TER. In gross terms the process works.

Where the process really differentiates itself though is not so much in performance as in risk. This better outturn over the index has been delivered with lower volatility than the market, the index and every other passive fund. Its standard deviation is 7% less than the index and 4% than its peers in the UK All Companies sector, many of which are multi-asset funds that would naturally have much lower volatility.

It is important to make one last point. The last four years have not been kind to funds with a value bias, as a fundamental tracker has. The implosion of the banks in 2008 took out almost 20% of the dividend stream into the UK market in the space of few months. In 2010 the accident to a BP oil well resulted in about 5% of the projected dividend income being withheld. Worst of all was the QE programme in the UK and US that pushed money into commodities and revitalised small cap stocks that were near death because of a lack of liquidity. The resultant rally in small cap, growth and eventually momentum stocks from March 2009 to January 2011 left value stocks trailing in their dust. A gradual rebalancing back to more normal markets started in February 2011 and was accelerated by the correction in August 2011. Even so, many value stocks still look over-discounted and many anomalies remain. There is still plenty of room for fundamental tracking to add a lot more value in the years to come.