Darwin, Japan and the origin of outperformance

July 26, 2013 6:02 pm

Darwin, Japan and the origin of outperformance

By Merryn Somerset Webb

Things that there are too many of. It’s a long list. But if you turn your thoughts to the financial industry you will see that the standout is investment funds. I have no idea how many funds there actually are available to chip away at your savings in the UK, but you can choose between over 2,000 at the top fund supermarkets alone. On that basis I would guess at 7,000-10,000 in total.

Most of those will be rubbish one way or another, which of course is why the average active fund regularly underperforms any given index. So here’s an interesting thing to wonder about at the beach this year: what if a 20-year bear market meant none of the big houses bothered to market funds in one particular sector any more?What if they also closed down a good few of the funds in that sector? And if all the managers not dedicated to it, or for that matter not much good at it, chucked in institutional money manipulation and retired or wandered off to become buy-to-let landlords in the UK instead? Might you then be left with a hard core ofgood funds run by clever people who know their market and can prove once and for all that it is possible for active fund managers to consistently outperform? Darwinism in action.

This might sound like crazy talk. But a report just out from Simon Evans-Cook of Premier Multi-Asset Funds suggests that this is exactly what has happened in Japan. I asked a couple of cynical wealth managers this week how they thought the average UK fund investing in Japan had performed relative to the index recently. They guessed, as expected, that it had underperformed. But, according to Mr Evans-Cook, they are completely wrong. In fact the average fund (as judged by a weighted index*) has returned an annualised 6.1 per cent over the past five years and has beaten the index (the FTSE Japan) impressively – by 9.9 per cent.

Clearly, investors in some other countries are losing out to UK investors, since the average of all funds everywhere has to underperform thanks to the effect of costs. But as Mr Evans-Cook notes, “for UK investors, active management of Japanese equities has been worth paying for”. He puts this down to Darwinism and to the smaller size of today’s Japan funds – work in a bear market long enough and you always end up with a small fund.

It’s also because the long bear market has created an “understandable bias” to value investing among UK fund managers looking for holdings in Japan, and value investing is the strategy that has the best record of working over the long term in any market, including Japan. Take this market in isolation and you could, should you fancy it, claim that it tells us that good active fund management works. So investing is just about finding a good fund manager. No more, no less.

Naysayers will say that it tells us nothing of the sort. Instead it tells us that the Japanese market is still jammed with zombie companies that only a zombie manager would buy. Anyone who doesn’t buy them will outperform the index. It could also tell us that as foreigners are really the only net buyers of Japan, it is obvious that the stocks they like or at least understand will outperform the others – in Japan, you could say that lazy fund managers effectively create their own outperformance.

Add it all up, and as one ex-manager pointed out to me this week, only a fool could underperform the Japanese market as a whole.

This might be entirely true, but as I pointed out to him, there were clearly a lot of fools working in the Japanese market in the 1980s when the Nikkei soared to 39,000. Either way, I think the point is made. In most markets, thanks at least in part to the fools, it is easier (and often kinder to your savings) to choose a passive fund over an active fund. In Japan, if you are investing from the UK at least, the opposite is true.

This brings me to an area where Darwinism has been markedly absent for some time – emerging markets. Here, the new launches have been coming thick and fast for years. Asian income funds, consumer spending funds, property funds. You name it, someone’s launched it. Those someones will include some fools and some very smart people. I haven’t got numbers for their relative performance but my guess is that right now, neither group will be particularly happy. The MSCI Emerging Markets index has disappointed horribly recently and is down another 10 per cent this year so far.

The good news is that these falls are finally shifting stocks back to the right price. In 2007, the emerging markets as a whole traded on a very silly cyclically adjusted price/earnings ratio (CAPE) of over 30 times. Now that number is 13 times (the US is currently on about 24 times). Prices might well go lower, but at these levels they are getting interesting. I’ve been avoiding emerging markets for ages but I think it is time to buy again – in a small way for now.

First State’s Global Emerging Market fund has a better record than most. If there were a 20-year bear market, their managers would still be standing at the end. First State is imposing a 4 per cent initial charge on investors from September in an effort to limit the size of the fund, so if you are thinking of buying, do so now.

If you want an investment trust, you might look at Genesis Emerging Markets Fundwhich trades on a 9 per cent discount to its net asset value.

* http://www.premierfunds.co.uk/m-a/state-of-the-universe.html

Merryn Somerset Webb is editor-in-chief of MoneyWeek. The views expressed are personal

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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