You can spend the rest of your life trying to discern what it is to be truly rich, but there's little doubt that my three favourite listed fund managers have been making their shareholders good money. The chart below shows their performance over the last 12 months:
Personally, I own shares in Fiducian Portfolio Services Limited (ASX: FPS) and Australian Ethical Investments Limited (ASX: AEF). I'm sitting on gains of over 65% (excluding a generous dividend) on the former, although my gains would have been more impressive if I hadn't been selling shares on the way up. In a much shorter time, my shareholding in Australian Ethical is up over 30%, not including dividends. I haven't sold any of those shares, and I'm not likely to either.
The trick with investing in a fund manager is to buy shares when the market itself is fairly undervalued. After all, a buoyant market is particularly beneficial to fund managers, whereas a falling market is particularly harmful. That's because when the market is going up, even an index-hugging fund manager will grow assets under management (AUM), and they will also find it easier to access new funds. In comparison, as the market falls the typical index-hugger will see AUM fall, and flighty clients redeem into cash.
I would therefore be sceptical of claims that fund managers are a low risk investment. Indeed, it upsets me to think that some people might be joining the bandwagon too late to enjoy a favourable risk reward profile, although that herd does provide my alpha.
However, there is likely further upside for many fund managers, the potential for the market to face a correction – and hit fund managers hard – is all the greater the higher the market goes. By my calculations, we are already likely to be in the latter end of a bull market. Certainly, the S&P/ASX 200 (INDEXASX:XJO) looks on the expensive side according to my preferred measure, although it certainly has room to run further.
Another thing to look for in a fund manager (or any company) is a sustainable competitive advantage. That's why several of us at the The Motley Fool also like Challenger Ltd (ASX: CGF), Australia's biggest provider of annuities. Usually, I'll run a mile from a fund manager with over $5 billion of assets under management, because such large organisations have a hard time justifying the fees they charge.
However, for an annuity provider, size, track record and financial strength are extremely important, as customers must be able to rely on the company continuing to exist. The smaller managers I own – Fiducian and Australian Ethical – simply wouldn't have the financial grunt to run a big annuity business.
To quote the Challenger website, "annuities provide regular payments for your lifetime in exchange for an initial capital investment, regardless of how long you live or how share markets perform." The company therefore faces both a headwind and a tailwind. The headwind is that more and more people are reaching an age where an annuity is attractive. The tailwind is that people are living longer, making it difficult for Challenger to predict its liabilities accurately.
It's pretty clear that Fiducian has a good strategy of simply acquiring small financial planning practices, and Australian Ethical has a massive head start over the competition when it comes to socially responsible investing. In fact, more and more people are piling onto that bandwagon with Simon Sheikh, John Hewson and a bunch of people originally involved with Australian Ethical promising to start a new fund – Future Super. The new fund will take advantage of Australian Ethical's questionable decision to invest in Westpac Banking Corp (ASX: WBC) and market itself as the only superannuation fund truly free of fossil fuel exposure.
As a shareholder in Australian Ethical, I think they should divest from Westpac and match the competition before Future Super has even started. There's simply no matching Australian Ethical's track record, and while I'm glad they didn't divest their Westpac shares in 2010 (when St George merged with Westpac), it's time they acknowledged that it is now 2014. Ethical investors like me no longer want to invest in fossil fuel financiers like Westpac.
Of the three fund managers discussed above, I consider Fiducian to be the best value, Australian Ethical to be the second best value, and Challenger to be the most expensive. However, each has its relative strengths and weaknesses. Investors should also note that Challenger is currently raising capital.
