The past five years should have been a wonderful period for the owners of international fund managers. The MSCI World Index has almost doubled. Institutional and retail investors have been steadily increasing their allocations to global equities. Yet the ASX’s two highest-profile global managers, Platinum Asset Management and Magellan Financial Group, have both experienced 80% share price falls since the end of 2019.
Platinum and Magellan's fall from grace
Source: Bloomberg
That share price performance has come on the back of extended periods of underperformance from both companies’ flagship funds, leading to persistent and significant investor withdrawals. From a peak of $26 billion, Platinum now manages a touch over $10 billion and suffered more than $840 million in net redemptions in November alone. Magellan’s outflows have stabilised—as has its share price throughout2024—but with $39 billion under management, the company is a shadow of its former self (at its peak in November 2021, Magellan managed $100 billion of investor money).
The founders of both companies, Kerr Neilson at Platinum and Hamish Douglass and Chris Mackay at Magellan, were all incredibly generous with their time when I was running the investment newsletter The Intelligent Investor. As investors who see stocks as shares in businesses and with contrarian bents, our investment philosophies are somewhat aligned. Over the years, I have recommended a number of friends and clients to invest in Platinum products.
Thus, their fall from grace has caused me a significant amount of angst and introspection. For shareholders, fund investors and competitors like us, there are lessons that must be heeded.
Fund Managers are risky business
I’m sure some Platinum and Magellan shareholders are scratching their heads. How does a highly profitable business with a rock solid balance sheet suffer an 80% share price fall?
Platform businesses like ASX-listed Pinnacle—where the listed company takes minority equity stakes in a stable of fund managers and provides back office and distribution services—are resilient and have an important role to play in an ecosystem where scale is becoming increasingly important. But the single-manager listed fund manager is a business to be wary of.
They can be wonderful, cash generative, capital light and high-margin businesses when funds are flowing in. At its Initial Public Offering (IPO)in 2007, Platinum’s pre-tax profit margins were more than 90%—its operating costs were less than 10% of revenues. All of those qualities work in reverse, however, when the Funds Under Management(FUM) decline. As both Platinum and Magellan show, once a funds management business starts seeing regular consistent outflows, it is almost impossible to arrest the momentum. Institutional money, where the decision maker is looking for someone else to blame, can be quick to flee. Retail investors take a lot longer to lose faith, but once you have lost it, it rarely comes back. The first thing that happens when performance recovers is a period of elevated redemptions. That might seem counterintuitive, but many investors hate selling at a loss. As soon as they get back to square, they send in the redemption notice(yes, I am talking from first-hand experience).
Platinum Asset Management Monthly Net Outflows
Source: Platinum Asset Management
*Data for 2H24 not yet available
So, if you are going to invest in one of these companies, you need to be confident that the outperformance that made them successful can be maintained. And, perhaps more than any other business model, success itself is what often brings the performance unstuck. Which brings us to the lessons for fund investors.
Size kills in active funds management
For Platinum fund investors, there are a few important lessons to consider when picking a managed fund. Beware extrapolating past performance, particularly when the track record was established with substantially less FUM than its current level. Size is the number one leveller in funds management, especially when investors can use index funds to own the world’s largest companies without paying active management fees. In June 2000, Platinum was managing just over $2billion. It tripled the amount under management over the subsequent three years, and tripled in size again by the time it floated on the ASX in early 2007. By the mid 2010s, Platinum was managing more than$20 billion. Forager had its own challenges, growing from $20 million to$200 million under management; more than $20 billion leaves you with a universe of almost exclusively well-researched, widely owned and very liquid stocks.
Next, watch out for changes in key personnel. None of these companies’ founders are working in the businesses today.
Sometimes, personnel change can result in a change in investment philosophy. Sometimes—I think this has been the case at Platinum—it can result in inertia. When an investment firm transitions from a founder to a committee or consensus-driven process, it risks becoming cumbersome in a constantly fluctuating investment environment. Platinum had 25 investment staff at the time of its IPO in2007. By 2021 it employed more than 100. Bigger is not better when it comes to managing money.
Adapt or die
None of this is good news for the wider active funds management industry. Canary in the coal mine is an understatement. Smoke is billowing out of the mine and the fire engines have arrived. In the US, more than US$3 trillion has been redeemed from actively managed funds over the past decade, and almost the same amount invested in index funds. There is now more money in aggregate invested in passive than active (in total, managed funds are roughly half the US market, with the remainder made up by direct retail, hedge funds and founders/insiders). Poor investor experiences with Platinum and Magellan will only add to the negative sentiment here in Australia.
It has been astonishing to watch an industry full of people ruthlessly dispassionate about the demise of other sectors—think traditional media and the taxi industry—struggle to accept the threats facing their own businesses.
Most arguments against low-cost index funds start with the incorrect premise that actively managed funds were actively managed. The large majority of money was with behemoths like Colonial First State and AMP, where active meant being underweight BHP by 0.5%. They were passive funds charging active fees.
Nor is there much evidence for the giant distortion theory. There are anomalies in today’s market, like the Commonwealth Bank of Australia trading at 27 times earnings, where index fund flows seem like a logical explanation. But why hasn’t CSL benefited to the same degree? By construction, the index funds aren’t playing favourites — every dollar that flows in gets allocated equally across the index.
Research from Goldman Sachs dispels several myths about the impact of passive investing on markets. A few fun facts for you.
There is no correlation between passive ownership and superior stock performance (the ‘Magnificent Seven’, giant US tech companies, which have driven so much of the US’s superior stock performance, have lower passive ownership than the market as a whole).
Stock price performance has become less correlated than it was, the opposite of what you would expect if passive flows were lifting all boats.
And fundamentals—predominantly long-term growth and earnings stability—still explain almost all of a company’s price-to-earnings multiple. An efficient market needs some market participants with a view on valuation, but there are clearly enough hedge funds, private investors and private equity funds to keep the market efficient enough.
There will be bubbles as investors get too optimistic about equity markets. Those bubbles will implode when those same investors get disappointed and choose (or are forced) to sell their investments at the worst possible time. But we had all of that prior to the rise of the index funds. Though they might be the medium through which the next bubble unfolds, index funds won’t be the cause of it—and at least they are a lot cheaper than the medium that came before them.
It’s my view that they are a predominant good for the world and that their share will only continue to grow.
Small and countercyclical
You know you are getting old when all of your Christmas social catchups end up discussing the worrying state of today’s youth. The worries are overblown—every generation thinks the ones that follow it are useless. And we have two wonderful, hard working, intelligent, seemingly happy twentysomethings at Forager. Either these two have slipped through the cracks, or plenty of them are alright.
It is true, however, that mental health and stress are a growing problem for young people. Talking to the older people in my life, less expectation definitely led to lower stress for previous generations. Work hard, pay off the mortgage, raise a family and call your life a success. Today’s young people want and expect a lot more, and social media pressures them to prove their success to the world.
While it is causing stress for many, the rise of index funds provides a simplicity to our purpose that is like living in the 1960s. There are not many things left that index funds don’t do well. Big blue chips at a very low cost were the first thing to go. Now you can also replicate quality, growth, value, and dozens of other factors in low-cost index funds. That leaves Forager with two clear areas where we can add value, and the past year has provided plenty of examples.
Index funds work best in markets that are already relatively efficient and where the value of stocks traded is high. The less efficient the market, the more value there is for active fund managers.
In stark contrast to large cap funds, almost none of which have been able to outperform the index over a 10-year period, small and midcap managers have a strong track record of market outperformance in Australia. According to Morningstar data, the more than 100 funds categorised as mid/small have outperformed the ASX Small Ordinaries by 3.5% over the past five years and 2.8% over 10.
Morningstar Category: Australia Mid/Small Blend
Source: Morningstar as at 30 November 2024
Identifying those smaller companies that can become future index constituents has been particularly fruitful, with Gentrack, RPM Global, Flutter and Ferguson providing wonderful returns to both Forager funds over the past year. To keep winning at the small end of the market, fund managers need to be willing to stay small themselves.
The other significant area of value is capitalising on the pro-cyclical nature of index-fund investing. Again, this is not a dramatic change from how the world worked 20 years ago. Fund managers have always been willing to launch a new fund to capitalise on the latest investor fad. But the speed of launch for index funds—no track record required—and accessibility via online brokerage accounts and 24-hour trading make for more dramatic rises and falls.
The Betashares Crypto Innovators ETF, launched at the peak of cryptomania in 2021, had lost 86% of its value by the end of 2022. Despite a 142% return over the past 12 months, it is still down more than 30% on its launch price. These factor driven flows can offer enormous opportunities for nimble investors who are willing to take the other side of the trade when panic sets in.
In the past five years, the PHLX Housing Sector Index (a US index of companies exposed to the US housing cycle) has halved, tripled, fallen 30% and doubled again. It is down more than 10% in the past month. We have our favourite structural winners in the sector, including Installed Building Products and Ferguson, but the sector’s popularity surges and slumps are wild. When the index funds are suffering outflows, the quality of the business is irrelevant. We can add a lot of value by giving our clients exposure to the right factor at the right time, often when everyone else is overly pessimistic.
I’m sure the ‘60s and ‘70s weren’t as stress-free as people think today. Likewise, running small, nimble, actively managed funds will throw up plenty of challenges. If the largest stocks keep performing better than everything else, those challenges could come soon. It has been a great year of returns, though, and our role in your portfolio is clearer than ever. With patience and willingness to stay small, there remains plenty of value to add.
This is an excerpt from the December 2024 Quarterly Report and also appeared on Livewire Markets as part of their Outlook Series