The secret to running a gold standard equities fund - and 2 that made the cut

2022 has been a year for many buzzwords in financial markets: inflation, interest (rates), and definitely "value". The S&P/ASX 200 Value Index is up 4.16% year-to-date, and as of writing, sitting at highs not seen since June. And when you compare the performance of value and growth funds here on the Livewire website, the difference has also become obvious.

But funds management is not all about performance (as important as that is). It's also about:

• the quality of the investment team running the operation, 
• the fees they charge, 
• how they invest or make investment decisions, and 
• the access to research. 

These also happen to be the exact metrics Morningstar uses to rate equity funds in both Australia and in most other markets. And even in a difficult year for markets, 13 of the 82 local funds analysed by its team managed to attain or retain a "gold" medal.

In this wire, I'll interview the analyst who heads up the team's coverage of these funds. I also share some insights from Katie Hudson and Michael Steele, co-portfolio managers of the UBS Australian Small Companies Fund. The fund was one of only two to be upgraded to the gold medal position, the other being the SG Hiscock ICE Fund. 

The approach

There are three main "pillars" to Morningstar's approach - summarised as people (the experience of the investment team), investment process, and parent (quality of the investment manager). 

A gold standard fund will generally rank "above average" or "high" on all three pillars, particularly on the people pillar. As MacMillan explains, it's not just about who the lead portfolio manager is but who the people are around them. 

"Morningstar analysis from annual reviews during the past five years indicates that an Australian equity strategy with a rating of High for the People Pillar typically has a portfolio manager with at least 15 years of tenure and 20 years of investing experience," MacMillan observed.

"The portfolio manager is normally supported by an investment team comprising at least six appropriately experienced analysts. In addition, the portfolio manager and analyst team will be highly motivated and extremely disciplined but have a collaborative and respectful relationship, with accountability clearly defined," he added.

One example that MacMillan highlighted was the Pendal Group Australian Equities Fund, led by Crispin Murray. Murray has been leading Pendal's local equities operation since 2003 and has a team of 18 people supporting him. 

The influence of a fund's performance

Unlike its main rival Lonsec, Morningstar's approach is unusual in that it's all-qualitative. A partially quantitative approach would have a bigger weight on historical performance data as well as reviews of various risk and return metrics. 

So does that mean performance does not matter to Morningstar's analysts? Not necessarily, says senior analyst Ross MacMillan.

"We consider a strategy’s long-term performance, not just against an index by also against category peers," MacMillan says. "Morningstar does not specifically rate performance as a pillar. However, the historical medium and long-term performance of a strategy are one of many factors considered by our analysts."

That's reflected in the gold medal rating for the Lazard Select Australian Equity Fund (W Class), run by Dr Philipp Hofflin and Aaron Binsted. MacMillan notes this is an example of a fund that is disciplined and consistent in its approach.

"Lazard’s investment process has been diligently applied through ‘thick and thin’ market conditions in the last five years and is now reaping rewards," MacMillan noted.

In turn, short term performance is not considered an important factor in a fund's review - a fact reflected in the two funds that were upgraded to the gold standard this year. Both are small-cap funds, which have recorded deep negative returns year-to-date.

Hudson and Steele's View

One of the two funds upgraded to the gold medal level was the UBS Australian Small Companies Fund. Although distributed by UBS, the fund has been managed by the Yarra Capital Management team since 2018. 

MacMillan and the Morningstar analysts based the upgrade on an increased conviction in the fund strategy and, in particular, the people who run it. 

"Hudson and Steele have a lengthy and collaborative working relationship from their days managing mid and small caps at Goldman Sachs Asset Management and have the support of a deep investment team at Yarra," MacMillan said.

That deep investment team consists of 13 additional analysts across the Yarra Australian equities team, in addition to other analysts across macro and fixed income assets.

But Hudson and Steele themselves believe it's all about sticking to a simple thesis.

"The upgrade to a Gold rating reflected Morningstar’s conviction in Yarra’s long-term and ‘through-the-cycle’ mindset, which has allowed the team to exploit timeframe inefficiencies in the small-cap market," they said.

What worked well this year?

Like most small-cap funds, outperformance has been tougher to find than needles in a haystack this year. Having said this, the Yarra-managed fund has outperformed the Australian Small/Mid Cap Index over the past five years (on a per annum basis). 

So what is the fund's secret to staying ahead of the index and its competition? Hudson and Steele say it's all about finding inefficiencies in the small end of town - and yes, having some exposure to lithium. 

"Positive contributors to performance over the last 12 months have included an overweight position in Pilbara Minerals (ASX: PLS), overweight positions in multiple mining contractors and an overweight position to Virtus Health (ASX: VRT) which was taken over during the period," Hudson and Steele noted.

As of the last fund update in October, materials as a whole make up 17% of the fund (second only to the financials sector). 

And how do they plan to stay ahead?

For Hudson and Steele, it's all about finding those opportunities that tick. Given the energy sector has outperformed so much this year, the team is looking at opportunities ex-energy as a way to capitalise on the market declines this year.

And yes, that includes going back into the growth trade.

"Growth has materially underperformed during calendar 2022, creating compelling buying opportunities for a number of growth companies. This has resulted in the portfolio moving to be overweight growth, in particular, technology," said the UBS duo.

"More recently the portfolio has started to establish small positions in a number of cyclical companies which have underperformed materially on the back of concerns of slowing global growth," they added while noting they are starting to take profits from those lithium names and defensive positions that did so well this year.

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I'll be in charge of asking the questions to Australia's best strategists, economists, and fixed-income fund managers. If you have questions of your own, flick us an email: content@livewiremarkets.com