Ben Gilbert: Can a leopard ever change its spots

Ben Gilbert, a portfolio manager at Sarasin & Partners, argues that a fund manager’s investment process should evolve with the market, but warns against simply chasing the current winning style. In his view, the most successful managers are those who make proactive, evidence-based changes rather than reacting to recent performance or drifting toward whatever is popular.

Markets change. Economies evolve. Technology shifts. Clients’ needs evolve. Fund managers must evolve too, or they risk falling behind. For much of the past decade, owning an increasingly concentrated market-cap-weighted index led by America’s largest technology companies has been a successful strategy. Recently, momentum has taken the baton as the seemingly unstoppable US mega-cap train has stalled.

Whether you look at value, growth, small caps, or international equities, leadership always rotates. Sometimes gradually. Sometimes abruptly. Timing has proved notoriously difficult to predict, but the broader lesson is consistent: markets change. Most clients are not paying for exposure to whichever factor happens to be leading today. They are paying to preserve and grow wealth over the long term. To beat inflation, deliver attractive risk-adjusted returns relative to peers and benchmarks, and to avoid unnecessary concentration risk.

As concentration rises, investor risk becomes increasingly exposed to fewer businesses. This is the structural risk of passive investing. Passive market-cap-weighted index trackers remain one of the greatest ever innovations in financial markets. They are cheap and effective. But they are not without biases. By construction, they allocate more capital to companies whose market values have already increased. This creates a feedback loop that can expose investors to significant risk if the dominant companies falter.

Proactive evolution versus reactive style drift

Recognising those risks no longer means abandoning passive investing altogether. Nor does it automatically justify paying high active management fees. Increasingly, investors have access to a middle ground. Equal-weighted indices, factor strategies, and other systematic approaches offer relatively inexpensive ways of addressing some of the structural risks within traditional market-cap-weighted portfolios. They are clearly active decisions, but transparent and rules-based ones. This can be used in an effort to manage risk rather than forecast the next winning style.

While evidence supporting persistent stock-picking skill exists, it remains mixed. Decades of academic research, including SPIVA scorecards, show that most active managers fail to outperform comparable benchmarks over long periods after fees. Changing style raises the hurdle even further. A traditional stock picker no longer needs to get just one decision right. They need to get two. First, identify the right individual companies. Second, correctly judge when one leading investment style is ending and another is beginning.

There is an important difference between proactive evolution and reactive style drift. Proactive evolution begins with evidence, not performance. It reflects changes in valuation, market structure, regulation, technology, or the opportunity set. It is signposted clearly to investors. It tends to happen before disappointing returns force the issue. Reactive style drift looks rather different. The old philosophy underperforms, while assets leave and yesterday’s convictions quietly disappear. Today’s portfolio starts resembling whatever has worked most recently. The rationale often follows the decision rather than preceding it.

Most advisers and fund selectors find it hard to judge the difference. The questions become as important as the answer. Was the possibility of change considered before or during a period of tough performance? Is the rationale supported by independent evidence rather than recent returns? Has the underlying investment philosophy changed, or merely the way it is being expressed? Those are difficult questions. Changing style should come with an exceptionally high hurdle.

Changing style should come with an exceptionally high hurdle. It requires more than a persuasive narrative after a difficult couple of years. This debate may lead some to conclude that they should allocate less, not more, to discretionary stock picking. It is a high bar and most managers will not clear it. The few that do should not be criticised for changing their spots. They should be recognised for knowing precisely why they changed them.