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Sell Discipline

Date: 03 May 2022

As fund selectors, a fund manager’s sell discipline is one of the routine discussion points when investing in a fund. We saw a very public example of sell discipline in recent days, with the news that Pershing Square’s Bill Ackman had decided to realise a significant loss on his holding in Netflix after it became clear that he had made a mistake.

But how should we think about sell discipline from the perspective of buying and owning funds? Like many fund managers when investing in stocks, there are three common reasons to sell. I’d describe these as:

  • a change in thesis
  • a change in environment
  • better opportunity.

Change in thesis can cover a multitude of sins. You’ve invested in a manager and at some point, your conviction is challenged. We’ve talked about some of those aspects in previous podcasts. That might include change in team, significant change in process, capacity issues or performance out of line with expectations. Often the risk here is confusing poor performance, with poor performance outside of expectations.

The biggest issue with investing in funds in my view is selling the loser to buy the winner. Sometimes that is exactly the right thing to do if the thesis has changed, but as we’ve discussed before, selling purely on the back of short term underperformance rarely works out well. The way to guard against this is to be very clear about when you expect the fund to do well and, more importantly, when it is likely to struggle. Is there a particular market style that favours the fund? Do rising or falling markets tend to produce the best performance, and so on. If you have selected a manager who you think will outperform long term, exiting during a period when they were understandably weak risks simply repeating that mistake with the next manager.

We are clearly in the midst of a significant shift as we speak.

Moving on to change in environment, we are clearly in the midst of a significant shift as we speak. Presently, from an asset allocation point of view, there is a clear challenge of holding bond funds in a rising yield environment and a changing environment should at least make us consider if we have the right portfolio construction. With a balanced set of funds, it can often be a case of changing the relative weightings of funds that you retain conviction in - after you have taken a view that the environment is less suitable. For instance, those that reduced their growth exposure last year after the incredible outperformance in 2020 will likely be sitting more comfortably today than those that watched those funds become an even larger part of our portfolios. It might be that we end up selling funds on the back of the asset allocation decision, but often the fund has the potential to be held again at some later date. In contrast, a change in thesis will usually put the fund in the penalty box fund for an extended period. Of course, timing the market environment is never easy, and one could argue that holding a relatively balanced portfolio and relying on manager alpha is somewhat easier. Many will be comfortable taking some sort of view, and certainly for professional investors, this is one of the potential sources of alpha.

Lastly, a better opportunity. For an investor in equities this will likely mean a stock trading at a more attractive multiple relative to its future prospects, compared to what is already held. For fund investors this situation can arise from a number of circumstances. Sometimes it’s a new manager becoming available that you deem to have a greater ability to outperform given their process and resources, or perhaps even just a fund priced more attractively for a similar outcome. Where I am seeing this most is in the broad church of ESG. For all the many launches we hear about, there are certainly plenty of gaps or potential for upgrade in the universe, and product innovation. The other area is the investment trust universe. Here there is a somewhat closer correlation to equity investing. At the point where a trust moves to an unduly high premium or wide discount, a trade may be the appropriate action. That might be particularly the case where there are closely mirrored open-ended and investment trust vehicles where the main difference is the vehicle itself rather than underlying holdings and switching between the two can provide greater value. Today that most likely means investment trusts look relatively more attractive given a recent broad widening of discounts.

Performance is often a catalyst for a fund change.

Drawing this all together, on the one hand, performance is often a catalyst for a fund change, but we should all at least aspire to have a longer-term time horizon. How long should that be? I’d suggest at least 3-years and ideally, 5-years or more. If you exit a fund over a shorter-time period, then it should be for a clearly defined reason. That might be a material change with the management of the fund, unexpected behaviour outside of your original reason for buying, or performance outside of expectations. So, either a change brought on by manager action, or simply a mistake on your part as an investor. Sometimes when it is us that has made the mistake it can actually be harder to sell and there is the perverse incentive to hold on until it turns around. Ultimately this is what the sell discipline is for, to keep you disciplined.

When the environment changes or when you have the opportunity to upgrade your portfolio, I’d describe that as a more positive reason to sell or reduce. Here the balance is between tinkering for the sake of doing something, and the additional value add we as investors can offer. Even simple rebalancing at the right moment can be helpful. In the institutional world, the quarterly rebalance cycle of reducing the winners and adding to the losers is very much part of the process. Finding that undiscovered fund gem that has just launched and offers an upgrade to your current line-up can equally be additive, and why we spend so many hours meeting with new managers, most of whom will not result in further meetings but occasionally will be very fruitful.

So, sell discipline really is as important to a fund selector as it is for an investor in equities, neglect it at your peril.

This is a marketing communication and is not independent investment research. Financial Instruments referred to are not subject to a prohibition on dealing ahead of the dissemination of this marketing communication. Any reference to any securities or instruments is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. Investors should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future returns. You may not recover what you invest. This document is not intended to constitute financial advice.

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The value of your investments and the income from them can fall and you may not recover what you invested.