How to tell if a fund manager’s process pivot is a red or green flag

Change and evolution to an investment process are two sides of the same coin, the former a red flag to investors that something may be awry in the fund and the latter, a mark of true active management to steer a portfolio through changing markets.

It's a conversation which has been stirred up by the high-profile changes to Fundsmith Equity after manager Terry Smith unveiled that he had gone in the face of his ‘do nothing’ mantra and changed half of the fund’s holdings so far this year.

Read about the dozen buys Terry Smith made

Smith made his name as one of the most successful fund managers ever, implementing some very simple mantras, like ‘no nonsense, no market timing and no index hugging’, and investing for the long-term.

In his half year letter to investors where he detailed and explained the change in positioning, Smith insisted that this didn’t mean he’d stop investing in ‘good’ companies, far from it he argued, rather he was taking into account the momentum in stock markets in addition to the fundamentals.

Why should you worry if a manager starts to dramatically shift?

A manager’s investment process and philosophy form the backbone of their fund. Often it’s what brings investors into it.

Paul Angell is head of investment research at AJ Bell and part of the team behind the Favourite Funds list. When compiling the list, the team place a significant weighting to a fund manager’s process because part of the rating is based on whether they think the managers are skilled in exploiting particular market efficiencies.

So if a fund majorly deviated from its established process, Angell wouldn’t be able to have conviction that the new, virtually untested, process could achieve the performance profile they’re looking for or, play the particular role they want the fund to deliver.

Why a fund manager changes their mind about a stock

“We’d typically be very concerned by a major change in philosophy or process,” he says.

The retail industry and investors are still carrying the scars of what happens when a manager drifts from the core investment process too much: enter Neil Woodford.

The demise of the former star fund manager and closure of his namesake equity income fund was a saga which stemmed from Woodford moving away from what the liquid, income generating UK stocks the fund was meant to invest in into more and more unlisted, smaller companies.

Woodford was a case of a fund manager doing what Angell cautions against, fundamentally changing what and how they’re investing beyond a point of recognition.

But not every change a fund manager makes is a red flag. Active management involves and indeed demands evolution, and some of the most successful funds today have navigated the balance whilst keeping to the spirit of the fund.

Indeed, Fundsmith Equity itself has form for this, after Smith tweaked the sell discipline to allow him to hold companies for longer if they showed signs of momentum a couple of years ago.

Rathbone Global Opportunities' ‘secret sauce’

James Thomson, manager of the £3.2bn Rathbone Global Opportunities fund, is an example of someone who successfully evolved his investment process to the benefit of investors.

Prior to 2007 the fund had a different set of buy principles which saw Thomson owning an airline business which went bust on Christmas Eve and is not something that would make it into the portfolio today because the main drivers of that firm’s success were outside of its control.

Thomson’s fund suffered a near 40% fall during the 2007/8 financial crash, an event which saw him shift to his now renowned ‘secret sauce' method which demands that he keeps his optimism about stocks pegged for massive periods of growth by the market in check.

Almost 20 years on, the fund is up over 600%, ahead of the average global equity fund, according to data from FE Analytics.

Scottish Mortgage and private equity

Another case study is Scottish Mortgage investment trust (SMT), one of the most well-known and successful of its ilk.

Over 10 years it’s made the highest returns of any global equity trust and a big portion of that success comes from its holdings in private equity.

SpaceX debuted on the Nasdaq earlier this summer in the biggest IPO in history, allowing any and all investors to partake in its space economy vision. But SMT had already been invested and benefitting from SpaceX’s rise since 2018, as 30% of its portfolio is allowed to be invested in private equity (PE).

SpaceX isn’t its only success story in PE, now owning seven of the world’s 10 biggest unlisted firms, including TikTok owner ByteDance, and AI heavyweights Anthropic and Databricks.

Telling investment themes from frothy 'fads'

Lead manager Tom Slater has repeatedly exalted the benefits of being able to invest in private companies as firms stay unlisted for longer and their ability to partake in that growth has been key to the trust’s overall performance.

But this 30% private equity remit was not always in place, and indeed just this year the board moved to try and give Slater and his deputy manager Lawrence Burns more breathing room to invest in private companies.

SMT was founded in 1909, but it’s only been able to invest in PE since 2012, initially with a 10-20% limit. This was increased to 25% in 2016 and in 2021 shareholders approved today’s 30% cap.

This year, SMT’s PE investment approach went through a further shift with shareholders approving an additional £250 million capacity for the managers to make new or follow-on private investments even when the 30% ceiling has been breached. So a big part of what makes SMT the portfolio it is today wasn't really part of its investment makeup just 30-years ago.

As an investor, you want your fund manager to stay within their pre-agreed set of investment rules. That’s part what helps you as the investor feel confident in what you’re owning. But there is space to evolve an investment approach while being true to the legacy of what brought you so far. And with active fund management under increasing pressure from passives, taking a hands on approach is arguably what’s needed.