Update No. 149 – 08/02/14

One of the trickier things for investors wishing to have their funds externally managed is (obviously) figuring out where they are likely to get the best returns. The finance industry is filled with warnings such as ‘past performance is no guarantee of future results’.

That is obviously true, and I would hazard there are plenty of money managers who ‘jagged’ a good 1 or 3 year benchmark trouncing record and benefitted from big inflows before their results returned to levels reflecting the true ability of the underlying manager.

Furthermore, plenty of money managers would have started funds at fortuitous times and although perhaps not beating the market particularly, boast good track records due to fortunate timing. Despite quite satisfactory returns in the nearly 3 years since founding, had EGP Fund launched just 2 years earlier, both the actual and relative performance would be markedly better than the returns tabulated below.

It is quite right that past returns/performance do not guarantee future performance, but as I have stated previously, benchmark outperformance, I would hazard has some strong correlation. If one were to select an externally managed portfolio based on investment managers that have a record of outperformance over a 3 – 5 year period, it is likelier than not such a portfolio would outperform over the ensuing 3 – 5 year period. If the ensuing period was one of very poor benchmark performance, it is entirely possible that the absolute performance may not be that impressive, but being a little better than the average over the long run will lead inevitably to satisfactory results.

There are two simple things the investor intending to have their funds manages externally managed should look for. The most important is the investment manager. The person responsible for capital allocation decisions is (unsurprisingly) crucial. I do not believe as a general principle, that ‘cultures’ of successful fund management can be relied upon. In simple terms, if a fund has built up a track record under one manager, do not expect the results to continue should a change of manager take place. There are some notable exceptions to this, but as a general principle, if you want to get similar results, follow the fund manager, not the organisation.

A second thing to look for are funds that return capital to their clients. Seth Klarmans Baupost Group has done this on occasion when cash balances outweigh investment ideas. Another notable example is David Teppers Appaloosa, “since 1993 Appaloosa Management had returned $12.4 billion to clients” (registration required). At the time that statement was written, the capital returned to investors exceeded the capital retained by Appaloosa. That is to say, had they desired it, they could have been more than twice as large. Investors who limit their size or return capital do it to ensure results remain strong.

Tepper presents an interesting example of steadily strong performance. This article touches on the 20 year anniversary of his fund, noting that a $1m investment at inception would be worth $149m on the 20^th anniversary. That is obviously very good, but the most interesting part of the article was actually this:

“Tepper got better with age… Over the past 20 years, he generated gross annualized returns of 36% and net returns of 28.44%. In the most recent five-year period, Appaloosa posted annualized gross gains of 39.34% and net gains of 30.54%”

So past performance WAS indicative of future results. Appaloosa was managing a good deal more money at the start of the most recent 5-year period than the $57m they kicked off with, but Tepper still squeezed outstanding results. The investment operation of Appaloosa ranges across a much wider range of investment opportunities than most, so comparison with benchmarks can be tricky. I would think that Appaloosa is likelier than not to outperform over the next 5 years also, provided David Tepper remained heavily involved.

The start to 2014 has not been nearly as good as the start to 2013 – this time last year we were up 12.2%, but despite ups and downs over the next 4 ½ months ended at that same level by mid-year. You can never tell where the ups and downs will come with the markets, that’s part of the fun though… – Tony Hansen 08/02/2014

EGP Fund No. 1 Pty Ltd. Down by 2.40%, leading the benchmark by 1.01% since January 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 60.35%, leading the benchmark by 39.35% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}