A fund of funds: Affluence Funds Management

Daryl Wilson is the Director, CEO and Portfolio Manager of Affluence Funds Management.

The Affluence Investment Fund invests in other managed funds, putting together a portfolio of what they believe to be the best of breed fund managers.

I spoke to Daryl to find out how he picks the right fund managers to go into his portfolio.

Daryl, Affluence Asset Management is a fund manager, which invests in other funds.  So essentially, it's a fund of funds.  I thought an interesting way to start out would actually be to see what's the absolute worst way someone can actually select a fund?

Thanks Mitchell, look there’s a couple of things that we steer clear of.  The first one is if you pick the top performing funds from the last couple of years, the one that has done 20 per cent per annum two or three years in a row, you’re setting yourself up for a big disappointment because performance is very cyclical and asset classes are cyclical.  We avoid those even though we look for a very good long-term track record.

The second thing is, and this more applies probably to, for example, the LIC market, if you choose based on dividend yield alone, similar to if you choose the shares with the biggest dividend yield, you may well be setting yourself up for disappointment.  That's never really a good sign of quality.

The third one is choosing the biggest funds, the ones you've heard of, the brand names, because there’s a few sources of out-performance, or what we call alpha, and one of them is actually choosing smaller funds with less money in them rather than the big behemoth that struggled to beat the average.  They’re the top three of things to perhaps be very wary of when you are looking at funds.

Jumping onto a rating's website, ordering the managed funds by the highest return over one, two and three years and then just picking the top, probably not the best?

Certainly, over one or two years, probably not.  If, you are looking at over five or seven or ten years, you are much more likely to find something with staying power and a good long term number.  But, short term one to three years, in fact, we have just put up on our website in the last couple of weeks a study from a US firm.  They did a study over 25 years and they studied all funds that had performed over the last three years and there was a clear relationship in that the best performers over the last three years, performed worse than average over the next three years.  But, even more interesting, the worst performers in the last three years, actually went on to out-perform quite substantially over the next three years.

Similar to the old dogs of the Dow theory in stocks, you can actually do better just by picking some of the worst short-term performing funds.  It sounds a bit weird but, it comes down to the fact that performance is cyclical and investment styles are cyclical, asset class performance is cyclical and so if something demonstrably hasn't worked for the last little while, it may start to work in the future.

Daryl, tell us a bit about Affluence Asset Management?  How did it come about?  How you actually build your portfolios and maybe a bit about your background as well, because I believe, you came out of property investing?

Yeah, I did, so there's myself and Greg Lander who works with me in Affluence constructing the portfolios and running the investment funds.  We worked at a company called Cromwell Property Group for around fifteen years.  That was our background, property.  But then we branched out in the last few years of that to also look at not only unlisted property but also listed property and we also partnered with another fund manager to look at a small company's fund and those were very successful.

When I made the decision to start Affluence, the basic premise was to say, can we take some of the things we have learned out of the property space and out of that small cash investing space and apply that to everything.  The basic idea when we started Affluence and when we invented the Affluence Investment Fund was to say okay, what if we created a fund that was kind of a one-stop-shop?  What if we created a fund that was the way, firstly, that we wanted to invest our own money; and then secondly, that had the features that we know from experience, investors are looking for. 

In the Affluence Investment Fund and in our other funds, those kind of design features are common.  We target 5 per cent per annum cash distributions; we aim to pay them as regularly as we can, quarterly or monthly; but we look to invest through other managers who we think can out-perform; we look to manage the downside, in terms of saying, well if we have market correction, we really want to be comfortable we’re going to do better than average; and we understand we’re here for the long-term.  We are not sitting here saying I'm not worried about this month or this week or even this year's performance.  I’m here thinking about 3, 5, 10, 15 and 20 years because that’s how long I want to invest.

That was our starting point and we just went off and the first really six months we just spent looking at every managed fund, every LIC in Australia and it is actually quite easy to narrow the list down.  I mean there are ten or fifteen thousand managed funds in Australia if you just screen for the ones that have out-performed over three years and longer by a reasonable amount.  Say, 0.5-1 per cent after fees, you eliminate 90-95 per cent of all managed funds.  So, it is quite easy to get the field down to a much more manageable number.  Then our hard work starts at getting together a portfolio of those funds and managers and LICs.  That is one diversified; and two, we think can continue to outperform.

When you say diversified, when holding a number of funds, and from your website I saw that you would likely hold 20 to 35 different investment vehicles within your particular fund, you’ve instantly got diversification there of course, across funds managers.  But you're talking about asset classes as well, is that right?

Correct.  Yeah, we diversify clearly by fund manager, but for asset class and just as importantly as well by investment style and so by that I mean we have managers that have a growth focus, managers that have a value focus, we have managers that run different strategies like, long/short and market/neutral and all of those different styles, even just as importantly as asset classes, will out-perform at different times and that helped us a lot to kind of move out the bumps and the hollows by having those different managers.

Do you look at things like say a multi-sectored growth, or multi-sectored balanced style portfolio?  There is plenty of them out there, and say, we want to get a similar asset allocation to these?  Or, are you more fluid in your asset allocation and say, you want to head more into Australian equities than other people, more into international equities than other people or more into property, et cetera, based on your in-house view of value?

Look, the answer is, a little bit of both.  Around eighty per cent of what we’re trying to do with a portfolio is just purely diversifying amongst what we think of as very, very good managers and then 15-20 per cent will be tilts towards where we see value.  We look at value in terms of what as an asset class or a fund or a sector worth right now, compared to its long-term average.  At the moment as an example of that, we’ve seen actually quite a lot of divergence.  Commercial property is very expensive, bonds are very expensive.  Within equities, you are seeing high growth stocks are very expensive, the lower growth and value stocks are incredibly cheap so we’ve got a tilt towards that sort of area right now. 

What we’re trying to do there is add value.  We’re trying to add value through finding managers that can out-perform; we’re trying to add value through having tilt towards areas we see value; and we are also adding value by looking everywhere, if you like.  Within our portfolio, you’re going to see different types of asset classes, different types of strategies; we've got a couple of hedge funds in there.  We’ve got a fund, a small weighting that invests in electricity futures that’s had a very good long-term track record.  We've got wholesale funds, retail funds, some of them, about a third of them are closed to new investors, so people can't necessarily access them themselves.  You’re seeing a very good mix of different styles and types of funds within our portfolio.

Right now you are seeing value in those value-based managers, because, I know if you listen to say a lot of the content coming out of the US et cetera, there has been a lot of talk about growth, investors of growth fund managers have had the run of the market, for quite some time.  You now do see that starting to trend back towards value?

I think it’s hard to know.  What we say is, we can recognise that an investment is cheap, but we do not know when that will kind of mean revert or turn-around, if you like.  But the cheaper something gets, the more we want to own it and what we’ve seen, in fact, we haven't seen demonstrable signs of that turning around right now.  What we have seen over the last calendar year and, in fact, for the first three months of this year is exactly the opposite.  What's happened is that, that rubber band has got stretched even tighter.  Things that were expensive have got more expensive and things that were cheap have gotten cheaper.  That actually makes us even more excited about our portfolio because we do have a rather large tilt towards deep value, small caps and some of those sectors that are fairly unloved at the moment.  There are some unbelievable bargains within that part of our portfolio, we think.  But you’ve got to be patient, you’ve got to sit there and go look, we know this is cheap, we know we’re pretty sure we’ll get a decent return out of this fund, this asset, but it could take one year, three years of four years, we don't know.

When you are looking around for those managers, say you have done a little bit of initial research.  Let's look at that quick checklist for the initial research first, then maybe dive-down into maybe questions you’re asking the managers, or what you are looking for when you meet the managers face to face because, I presume you do go out there a meet them face to face before you invest in the funds?

Absolutely, and that’s an incredibly important part of our process.  It’s the art rather than the science part of our process, but that first manager interview is incredibly important.  But before we get to that, generally, we’ve identified a potential manager through either, someone has made us aware of it or we’ve done some performance screens.  Generally, what we’re looking for there is a very good long-term performance, and by long-term I mean five years or longer, by the same team.  We’re not interested in new funds or a team that’s come from different areas with different track records, we’re looking for a group of people who have a very good long-term track record that we can assess. 

Then we look at thing like the investment environment.  How they’re set up, how they’re structured.  So, for example, one of our important checks is that the fund itself has to be domiciled in Australia.  We’re not interested in trying to work out how to go to the Cayman Islands and invest through a fund and deal with all the different regulatory environments and tax environments there.  We look for generally managers who have what we call a boutique type set-up.  What that usually means is two things, firstly, that the investment team has money in both the fund and the company that manages the fund and secondly, that they are free to invest within their circle of confidence so, they’re not constrained by limiting how much they can put unfairly into a certain type of asset or a certain area of the market.

Then we look at the strategy and have a think about what that's doing.  Whether we see value in that particular area right now.  That will determine how quickly we might look at a more detailed due diligence.  If it is something that excites us right now, we like to look at it immediately.  If it’s something where we think, well this is a great fund, but we’re just not that enthused about exactly that area right now, we’ll kind of park that, keep an eye on it and perhaps look at again in the future.  We run generally between 80-100 funds outside of our portfolio that we’re keeping a close eye on and then we've got about thirty-five or so in our portfolio at any given time, plus the LIC market which is another 50-60 that we keep an eye on.

When you do sit down and actually talk with these fund managers, what are the questions that you’re asking when you do actually meet them face to face to find out whether or not they've got an edge over the other 1,000 or so funds out there?

The first part is really getting our head around the investment process they’re using, the investment process; what's their competitive advantage; how is it that they can make an above average return over time; and does that make sense to us.  What are the things they’re doing that enable them to produce that out-performance?

Then more than anything else around that is actually just hearing them talk.  Are they passionate about what they do?  Do they understand what they’re doing?  Do they understand what their philosophy is, and are they living to that philosophy?  The important part of that is, we’re really drilling into the investment style that they’re using and because sometimes how a manager promotes their fund, is not necessarily what they’re actually doing.  They might promote themselves, where we might think of them as a growth manager, but when we talk to them, we might discover that well, actually they’ve got a mix of different types of investments that are neither growth nor value.  That's important to us when we are putting a portfolio together, so that we make sure that we have got that mix of different styles. 

Then we put a lot of faith in personnel traits that we see from managers as well.  Some common ones, as I mentioned being passionate.  Some common ones are also humility which means the ability to admit when you’ve been wrong, to understand that you don't know everything and to talk honestly about mistakes and importantly out of that to talk about the improvements you might have made to your process or the learnings you made out of that, that have made you a better investor.  Those are all things where we just keep people talking.

One thing that I know, talking to individual investors out there all the time is that fees are incredibly important to them when they’re looking at a fund manager.  How do you assess fees?  How do they play a role in your investment decision?  I'm thinking more along the lines, are they quite secondary to you, because you are looking initially for that manager and then if what they are saying to you ticks the boxes, if their style is unique or has a place in your portfolio, then fees is probably one of those things that are down the bottom of your checklist?

Yeah, look I wouldn't say that it's not important, but ultimately, I would say we’re prepared to pay for good performance.  The way we think of fees is first of all, we look at what is the performance net of fees.  One of our biggest bug-bears is when we look a fund manager that puts their performance in pre-fees.  Unless you’re going to do it for free, that seems a little bit dishonest almost to me, because it's about what the investor is going to get at the end of the day.  We always look at performance, net of fees and net of costs, but before any tax. 

Then we look at the results, and we look at the fee, and we ask ourselves whether the fee is fair reflection of the strategy and the work and perhaps the constraints that go around doing that work.  If you’ve got a manager running let’s say a small companies fund, and their investment universe is quite limited, and we think they could do very good results, say double digit or better over the long-term, we’re happy to pay them a reasonable ongoing fee and reasonable performance fee to do that. 

I say to people if you are focused on fees and we see that in a lot of institutional investors to their detriment.  If you’re focused on fees and fees are a deal breaker, then you’re probably not going to invest with us and you are probably not going to invest with almost any of the managers that we use.  But, as long as we see a fair fee for the results, we’re happy and conversely, I would say more than half of the managed funds out there are producing less than average results, less than market results for a much greater than market fee, and in that case, you’re much better to be in an ETF or an index fund, because you’re going to pay a very low fee and you’re going to get pretty much market returns and there’s nothing wrong with that either, that's just not what we do.

One of your largest investments is in a fund that you guys manage yourselves, which is your listed investment company fund.  I’d like to have a little bit of a chat about LICs with you as well.  A lot of people when they do look at LICs, they might instantly just look for whether something is trading at a premium or a discount to the underlying net tangible assets, the NTA of the LIC.  What they might do as well, is just dismiss, instantly anything that’s trading at a premium.  Is that part of your process as well?  Do you see a premium and then instantly say, put-off doing a bit further work into it?  Or, do you think there is still value in looking at these LICs that are trading, or have historically traded at a premium.

It's very, very difficult for us to buy an LIC at any sort of reasonable premium and I’ll explain why.  Firstly, we like the LIC market and we like it because it’s actually an incredibly rich set of accounts or funds managers in the LIC space.  You can get access to some very good managers and in many cases for the average investor, that's the only way you can access them.  As a starting point the performance set and the quality is much higher than managed funds in general. 

Unfortunately, the structure is not ideal, because companies are a much worse structure than the normal trust fund structure, it’s tax inefficient, but that’s probably a discussion for another day and something that might actually get changed over time, depending on what happens with franking credits.

We’re there firstly to capture the returns from this very good set of fund managers.  That's the starting point for us.  But also we supplement that by saying, actually these LICs have a very interesting feature and that is that the price does not necessarily equal the value of the assets or the NTA. 

We looked at those by buying a LIC cheaper than it should be and selling it, if it becomes more expensive than it should be.  To do that, you have to answer the question.  What’s the right price for every LIC?  It’s not net tangible assets because if it’s small or doing something weird and less liquid, it’s always going to trade probably at some sort of discount.  If it’s got very good long-term track record and it is quite large, it could in fact trade at a premium.

We’ve seen situations where LICs trade at, let’s say, 10 per cent premiums and above, now if we just think about what that means for a minute.  If you think that a manager is good enough to be able to out-perform the market by 2 per cent a year, let’s say, and I can tell you that would put any fund manager in about the top 1-2 per cent of everybody.  And, you’re paying a ten percent premium to access that manager, you’re effectively giving away the next five years of out-performance to be able to access them, and we think that's not the way to earn good money out of LICs. 

We try to do the absolute opposite.  We try and find to a degree, a manager that we think is at a 10 per cent discount, that maybe should be trading at net assets or maybe we buy one at a 20 per cent discount that we think can trade at 10 per cent.  Still, a good manager, but we think we can get a little bit extra out of buying cheap and selling less cheap.  That's what we love about the LIC.  I think people, if you are buying at a big premium, be careful.  We allowed ourselves to buy LICs at a premium when we first started the fund three years ago.  These days we just have a rule of no premiums because, even where we’ve done it and had very good manager, it hasn't worked out that well.  There are two or three out there in the last three years that have gone from 20 per cent plus premiums to a discount and that’s hurt shareholder returns a lot.  You’ve just got to be super careful in LIC when buying premiums.

Looking to wrap-up here Daryl, you’re out there speaking to a lot of fund managers daily from a lot of different walks of life and invested in a lot of different spaces.  What's the general consensus view, from your opinion, on the Australian market going forward, post the election?

I think we are not macro-economists and so economics and economic forecasting doesn't play a huge part in how we construct our portfolio.  But what I will say is that, I think Australia has become incredibly pessimistic.  We usually want to put more money to work when we see uncertainty.  At the moment, we’ve got uncertainty over the election in Australia.  We’ve got uncertainty over China and US trade.  We’ve got uncertainty over Brexit.  We’ve got uncertainty over Aussie housing.  Whilst they’re all valid concerns, what tends to happen when you see this situation is what's priced in, tends to be a bigger impact than what ultimately happens.

The more uncertainty in markets we see, the more we want to invest a little bit more.  Out of all of those things, I think the one thing that we do worry about, is housing, and we keep a close eye on what is going on there because, it has the ability to bring Australia undone in a very big way if we see a very large housing correction.

Other than that, we think Australia just developed into this amazingly resilient economy, and it's punched above its weight for 20 years or more and given demographics and where we are and how we’re placed as a nation, I can see that happening for the next 20-30 years, easily.  We actually have a very big home bias when we look at investing.  We can invest anywhere in the world, but we choose right now, to have about three-quarters of our money invested in the Australian market because we feel that's where the relevant value is.

Excellent.  Well Daryl, thanks for joining us here today.  It's been great having a chat to you and how can investors find out a bit more about the Affluence Funds.

The easiest way to do it is to go to our website, which is affluentfunds.com.au and there is a whole heap of information there about our Affluence Investment Fund, our LIC Fund.  The best thing I encourage people to do it just sign up for our monthly newsletter and we’ll email you out the fund reports and what we think is going on in the world.  We would encourage people, always to get to know us and understand a bit about what we do before they invest.  Getting on that monthly newsletter is the easiest way to do it.  Of course, people are free to give us a call at any time, can speak to myself or Greg directly if you have any questions.  No problem at all.

Excellent.  Well Daryl, once again thank you very much for your time and we'll catch you next time.

Thanks Mitchell, appreciate it.

That was Daryl Wilson, CEO and Portfolio Manager at Affluence Funds Management.