Among the very select group of serial first-quartile performers, the JP Morgan Europe Strategic Growth Fund is the best performer. It has generated an annualized return of 15.45% over the past three years, quite a bit better than the second-ranked THEAM Quantitative Equity Europe Guru Fund (13.72%). It also suffered the lowest loss of the five funds in of the three years: during the 12 months to the end of March this year it declined only 5.01%.
The THEAM Quantitative Equity Europe Guru Fund is a smart beta strategy, part of BNP Paribas IP's Guru fund range. All five Guru funds have been inspired by investment techniques employed by investment 'gurus' such as Warren Buffett. The European variant proves a smart beta strategy can actually beat the bulk of active funds over a longer time period without having a strong tilt towards one specific factor. The quants-based fund assigns point to all stocks in its universe based on three factors, and selects those companies that earn most points in aggregate.
"The model looks at profitability, which can be compared to quality; prospects, or momentum; and valuation," explains Sébastien Denry, a quantitative equity specialist at BNP Paribas IP. The fund stands out from most other smart beta funds because it has a very high active share, which has ranged between 77.3 and 83.4% over the past three years.
"This is because the fund is not benchmark-driven," Denry explains. "The investment process is botom-up, and we have no relative risk constraints such as a maximum tracking error."
The five top-performing funds have little in common, apart from comfortably beating their peer group average over the past three years. The Threadneedle European Focus Fund, for example, has a heavy overweight to consumer staples and a concentrated portfolio of only 30 stocks. The aforementioned THEAM Quantitative Equity Europe Guru Fund, a smart beta strategy run by BNP Paribas IP, holds 102 stocks and has only half the weighting to consumer staples the Threadneedle fund has.
There is a common denominator, however, between the five funds: while the average active share, or the deviation from the benchmark, of a European equity fund is 69.6% according to Morningstar research, four of the five funds in question here have an active share above 80% over the past three years.
The exception is the JP Morgan Fund, which has an average active share of only 60%. However, this fund is benchmarked against the MSCI Europe Growth Index, while the other ones use a wider European stock index such as the MSCI Europe or Stoxx Europe 600 as their benchmark index.
The fact that the bulk of the consistent first-quartile funds have a relatively high active share suggests that this helps fund managers to achieve consistent outperformance. No wonder, since a high active share means fund managers’ ‘active fees’ (fees per unit of active share) are lower, thus increasing their chance to outperform after costs. However, the opposite is also true: if we don’t take skill into account, a high active share increases the likelihood of below-benchmark performance too.
Protecting the downside
Many investors buy active mutual funds rather than individual shares or index trackers because they look for protection against the downside. While most fund managers fail to outperform their benchmarks on the longer term, our research shows very few fail hopelessly over longer time periods. In fact, fund managers beat the proverbial monkey here: only two funds from our sample of 455 funds finished bottom-quartile for the past three consecutive 12-month periods, much less than the seven funds the laws of probability predict. Moreover, the BBVA Bolsa Europa Fund and the Parvest Equity High Dividend Europe Fund, despite being serial underperformers, still managed to generate positive annualized returns of 1.43% and 1.09% respectively over the past three years. The Parvest Fund has an active share of 72.8%, which is average for its peer group.
In the coming weeks, we will investigate whether similar patterns can be observed in other asset classes, such as US equities and emerging market market equities. That will give us a better idea about the question whether fund managers as a group are indeed so obsessed with limiting downside that they fail to deliver outperformance.