The stars are aligned

While star fund managers are few and far between, the most prominent names in the UK’s investment management community have built up loyal followings. However, star status is no guarantee of consistent outperformance and if returns begin to disappoint, investors and advisers may have some thinking to do.

Some followers of the ultra-high-profile Neil Woodford may feel they are in this position right now, with several of his funds having underperformed for much of this year amid setbacks for a number of the manager’s most-favoured stocks. Fans of Terry Smith, another widely-followed manager, may also be feeling concerned about the underwhelming performance of his Fundsmith Emerging Equities Trust this year.

This isn’t to suggest investors in these funds should cut and run – both Smith and Woodford acknowledge the short-term issues their funds have encountered but urge investors to focus on the long term. Both managers have track records that should provide some confidence that long-term performance will be much better.

Nevertheless, the travails of these star managers raise some interesting issues about the way the fund management industry operates. How easy is it for investors to hold high-profile managers to account during difficult periods? When a fund management firm’s fortunes depend on its star manager, can investors be confident the right questions will be asked internally? And above all, is the fund really being run in the interests of investors front-of-mind?

These are essentially issues of governance, a concept that investors don’t tend to think about when making asset allocation decisions and choosing collective funds. That may not be a problem when their funds perform well, but the question of accountability moves front and centre during periods of less impressive returns.

It’s here that the investment company sector has an important contribution to make. Closed-ended funds such as Woodford’s Patient Capital Trust and Smith’s Fundsmith Emerging Equities Trust are stock market-listed companies with the same legally-binding fiduciary responsibilities as any other publicly-owned company structured in this way. Most importantly, these companies must have independent boards with a legal duty to safeguard the interests of shareholders.

That’s a very different set-up to an open-ended fund, which is an investment product sold to investors by a fund management firm. The firm naturally hopes the fund will perform successfully – not least so it attracts more of investors’ money and generates higher fees – but there are no in-built mechanisms to ensure its management is accountable to investors.

These contrasting governance arrangements should give investors in all funds pause for thought, but the issue is particularly pressing when you’re considering funds run by star managers. In an open-ended fund structure, investment management companies may be very reluctant to ask searching questions of their star managers. Not only are they the geese that lay the golden eggs they’re also very often the head of the business as well as its lead fund managers.

In an investment company, however, the board has no choice but to tackle the manager on shareholders’ behalf – if it did not do so, it would be in breach of its fiduciary responsibilities.

It may very well be that Woodford and Smith will repay investors who keep the faith. It would certainly be wrong to judge them on such a short period of disappointing returns. Nevertheless, those investors who have bought exposure to these managers through an investment company can take comfort from the fact that even these big names have to work with independent boards that scrutinise their performance and hold them accountable.