The Rise and Fall of Active Fund Giants: Lessons for Investors

In Episode 34 of Stocks Neat, Chief Investment Officer, Steve Johnson, and Portfolio Manager, Gareth Brown, take a deep dive into the challenges facing active fund management giants Magellan and Platinum, and the lessons for investors seeking long-term outperformance. They unpack what’s gone wrong, the rise of ETFs, and why small-cap opportunities remain a crucial edge for Forager.

The discussion explores industry trends, the impact of fund size on performance, and how Forager stays nimble in an increasingly passive market. With insights on market dynamics and practical tips for identifying standout active managers, this episode is a must-listen for thoughtful investors.

“Outperformance in active management is hard to find. It’s about being different and being right, which becomes increasingly difficult as funds grow larger and markets shift.”

Transcript

[INTRODUCTION] 

[00:00:03] ANNOUNCER: Just a quick reminder, this podcast may contain general advice, but it doesn't take into account your personal circumstances, needs, or objectives. The scenarios and stocks mentioned in this podcast are for illustrative purposes only and do not constitute a recommendation to buy, hold, or sell any financial products. Read the relevant PDFs. Assess whether that information is appropriate for you. And consider speaking to a financial advisor before making investment decisions. Past performance is no indicator of future performance. 

[EPISODE] 

[0:00:40] SJ: Hello, and welcome to Stocks Neat. I'm Steve Johnson, Chief Investment Officer here at Forager Funds. And I'm joined by my regular co-host, Gareth Brown, for our December quarterly podcast. How are you, Gareth? 

[0:00:51] GB: Good. Thanks, Steve. Hi, everyone. 

[0:00:52] SJ: How's the year been? 

[0:00:54] GB: Busy. Very busy. 

[0:00:56] SJ: You're having a break? What's happening? 

[0:00:57] GB: Yeah, I'm taking about two weeks off, going down the South Coast in early January. I've got the kids at home for a few days over Christmas. My wife's working. And then we're going down the coast for a family holiday. 

[0:01:09] SJ: Very nice. Very nice. It's been a very good year of fun returns. It's also been a very strong year of market returns that seems to have accelerated into the end of the year post the election in the US. How are you feeling about the year ahead? 

[0:01:23] GB: Nervous. I don't think that's any different to usual, but markets feel a little bit stretched. And we often see regime changes happen around about New Years’ time. People are very nervous about what's going on in January and they start to move their positions. We'll see. I mean, we're not afraid of a bit of turbulence. In fact, it's good for us long run. But, yeah, I'm a little nervous that we might see it sooner than later. 

[0:01:48] SJ: Yeah, I think particularly in those pockets that have been, I guess, incorporating a lot of optimism about how much Trump's changes are going to help the economy and particularly domestic US stocks. I saw a stat the other day, I think 75% of the MSCI World Index is now US-listed companies. And It's almost become a theme in and of itself that America is the only place in the world to invest. Harvey and I did a podcast about 12 months ago saying it is a good place to invest for good reasons. But yeah, it certainly becomes self-fulfilling. 

[0:02:18] GB: I mean, I'm hesitant to use the word bubble, but that's the issue mainly as far. There’s usually a very strong kernel of truth in it. It's just what price do you pay for that truth? 

[0:02:27] SJ: Yep, and how far does it get taken? 

[0:02:29] GB: Correct. 

[0:02:29] SJ: We're sort of going to talk about a little bit of an adjacent topic today. It's has been the past five years have been something of a horror show for two of Australia's, I guess, formerly very well-regarded funds management companies in Magellan and Platinum. The share prices of the management companies, which are both listed on the Australian Stock Exchange have fallen approximately 80% over the past five years. And that's a period in which most indices have doubled or so. 

[0:02:56] GB: Yeah. 

[0:02:57] SJ: Platinum fund investors have certainly done better than that. It's not like they've lost money over that period, but the magnitude of the underperformance of indices there has been very, very significant. And a dollar invested there five years ago is worth roughly half what it would be worth if it had been invested in the index at the same period of time. It's been a very difficult time. 

And I think there were two poster child companies for the active funds management industry and their woes I think have some lessons for everyone in the industry and also for potential clients as well. Today, we're going to explore what's gone wrong. What some of those lessons are? And for those few people left trying to pick an active fund manager out there, maybe some of the things to think about when you're contemplating where to invest your money in the active space. 

Let's kick things off, Gareth. I mean, it's a sector that obviously you've invested your life in as a business, but also covered a bit from the outside in terms of looking at listed wealth management companies. What are some of the characteristics of it as a business? 

[0:04:00] GB: I mean, when it works, it's a very, very attractive business. We have relatively stable revenue line. It can be really high margin. I mean, you've seen Platinum back in the day at least was I think an 85 or 90% profit margin, meaning they're great. They were paying out 10 or 15 cents on the dollar of their revenues as wages and other costs. And the rest of it was falling through to the bottom line. Immense operating leverage for a business that's run well. And so, that means if you grab another billion of funds under management or another two billion, it falls through to the bottom line to shareholders very quickly. The inverse of that is also very true, that if you start shrinking, you can really blow up your bottom line quickly. 

[0:04:42] SJ: Yeah, very fixed cost basis there typically in terms of people. And they tend to be very cash-generative. I mean, even if you look at Platinum today, it's still a bucketload of cash on the balance sheet. They did pay out a big chunk of that as a fully franked dividend recently. 

[0:04:54] GB: I mean, mostly they're paying out. My feeling was that they have been paying out sort of a hundred percent of their earnings over the past 15 or 20 years. Is that right? 

[0:05:03] SJ: It might have been a bit less than that. There's some investments in funds and some other things that they've done on the balance sheet. And I think particularly as the outflows have accelerated, there's been a bit more conservatism there. But they did as part of this announcement a couple of weeks ago. just for a little bit of context here in terms of, I mean, the business Platinum that share price has been on a downward trajectory for some time. But just two weeks ago, they made an ASX announcement saying that Phil King's Regal, another listed wealth manager, had walked away from discussions about taking it over. And probably related to that, they had 800 and something million dollars of outflows in November for a business that now has a bit over 10 billion of funds under management. They're suffering very significant outflows. And as I touched on earlier, the relative performance has been very poor over extended periods of time now. Those outflows look likely to continue. 

I think it's really important that when you talk about fund managers as a business, there's a very wide spectrum of different types of businesses out there. And I think both Magellan and Platinum are at the riskier end of the spectrum. To your point, they can also be the most incrementally profitable that you can grow them. But when it's one investment strategy and often one person, there's a lot of key person risk there that is driving the inflows and even driving the performance and the investment philosophy. There's a lot of risk that the person leaves, the strategy stops working. I think we'll touch on this later. But perhaps the amount of money that they're managing gets too big to be executed well in the strategy. 

At the other end of the spectrum, you've got a business like Pinnacle that share price has been the inverse of what's happened here. It's been a very successful business over the past decade. And it's more of a distribution business. They basically have a fund manager in their stable for whatever is popular at that point in time. They're very good at selling the product. They're very good at doing the back end for all of these fund managers that don't particularly like doing all of the compliance and regulatory side of things. That business has proven itself to be a much more resilient business. It's not as profitable when you look at the profit margins— 

[0:07:12] GB: Yeah. The ability for a really one-person shop or starting as a one-person shop, at least one-person providing the outsize influence, you can grow these things very – or at least historically have been able to grow these things very, very rapidly. Yes, there's downside to that when care doesn't want to work there anymore or when management changes. But it's also maybe a prerequisite for that spectacular growth in the first place. 

[0:07:40] SJ: Yeah, that's exactly right. I think if you're looking at one of these businesses, I'd say one of those things is a more resilient business model than the other. It doesn't make it better, right? I think if you can find some of these companies at the right point in that growth trajectory, they can be extraordinarily profitable businesses. 

I remember when Magellan first listed on the stock exchange, you and I were both working in Intelligent Investor, you could have bought that in 2008 for less than the investment. You could have bought the management company for the less than the investment it had in its funds. From there, it went from four bucks a share to 60 or so at the peak. It was a very successful investment. It's just really important if you're analyzing as businesses to recognize that, "Okay, this is one philosophy here. It's one very important person." 

And I think if that person leaves, steps back from the business, they're always going to tell you a story about, "We've got this great team in place." I think it's just important that that has been a part of the sales strategy for a very long period of time in terms of just flows into the business. It's important to remember that their departure comes with very, very significant risks. 

One of the other things is just customer concentration. 

[0:08:53] GB: Wholesale money and retail money. 

[0:08:55] SJ: And I would say one is usually a lead indicator of the other. When you start seeing wholesale outflows, they can be much bigger. So that in and of itself is a risk. And you saw at Magellan some of the big early outflows were institutional clients themselves. People in that space are generally trying to blame someone else when something goes wrong. I'm talking about the clients here. They had a big UK customer at Magellan called St. James's Place. If you're working for St. James's Place and you're going out and talking to your clients and saying, "We're not delivering you great results here." 

[0:09:28] GB: Fire someone. 

[0:09:28] SJ: You've got to fire someone, exactly. That whole sale money tends to go pretty quickly. 

[0:09:33] GB: Yeah. And it comes in quickly, right? That's just the nature of beast, that if you're a fund manager with a decent track record and a good story, that wholesale dollar will turn up at some point and come in very, very quickly, and also have a tendency to depart quickly. 

[0:09:49] SJ: Yeah. I think really keeping an eye on what that concentration risk looks like. And then when the wholesale money starts to go, it is often a sign that there's something else here that is eventually going to lead to retail outflows. And everyone loves retail because it's a lot stickier. But I do think it just takes longer for people to reach the same conclusion. 

One of the really big warning signs is obviously performance problems. But I think people don't do enough rolling forward of what is this going to look like in two, three, four years' time. And you can actually do that as an investor in the management company and sit there and say that the fund manager might be saying the one-year number here is looking bad. But look at the three and the five-year numbers and they look great. You can sit there and do a bit of analysis about how is this actually going to roll off. 

[0:10:40] GB: Yeah. How is the five-year going to look next year? Yeah. 

[0:10:43] SJ: If it manages to match the market over that period, then what's it going to look like three and five years? And you can often predict those points in time where a lot of the clients haven't even looked at those numbers, but you get to six months, twelve months down the track and you go, "Okay, this is going to be looking pretty horrible as this rolls through." And we've seen that a lot in our own business over the past few years. We've had a couple of really lumpy years in there. And we've been doing very well for the past two years. We've actually done well over the past five years. But t as those lumpy years roll through, sometimes the three -year number looks terrible, sometimes it looks great. 

And you can sit there now and, for our Aussie fund in particular, say in March and April, these numbers are all going to look fantastic for a fairly limited period of time and then it's going to roll off. If you're investing in funds, we'll come to this later, don't be fooled by that stuff. I think you want to be sitting there and saying how the fund managers will often use that little window to market their fund very aggressively. But if you're an investor in one of these vehicles, I think it's worth doing some analysis of how that's going to roll through. And then I think a really big one is just size. 

[0:11:44] GB: Yeah. We're going to talk a little bit about the makeup of the industry versus ETFs and index funds. This sort of covers on some of that ground. But it's no doubt the most strategies, the bigger you get, the harder it is to outperform. We'll talk a little bit about the variance in that industry. But as what you can do with 500 million is very different to what you can do with 20 billion. And it gets incrementally much harder to outperform. And we think you have to be different to the market to outperform, but you also have to be right. And managing that subset with huge amounts of money, it's a herculean task. 

[0:12:24] SJ: And with both of these companies, it went from less than a billion dollars of firm to 10 billion to – 

[0:12:29] GB: 25. 

[0:12:30] SJ: – to a hundred in Magellan's case. About a hundred billion dollars. And it was a fairly concentrated portfolio still is today. But they were putting 5% of their portfolio into one stock. And all of a sudden, you go, "Okay, it's a hundred billion." I'm now talking about a five-billion-dollar investment. You're down to a very small universe. 

And the interesting thing about this is the business looks wonderful as all of these inflows are coming in, but it's actually the thing that's sowing the seeds of your downfall. If what you're selling is outperformance, you get all of the inflows on the back of outperformance. And it's actually the inflows that are going to kill your ability to keep delivering what's made you successful. That can be a very long period of time. And some businesses can adapt and manage to do a better job than others with more fun. But I do think it's something to be really careful of when you're investing in the fund manager as well is, is this now too big? Yes, I'm making great dividends and great profitability at the moment, but is it sowing the seeds for future underperformance that are then going to lead to the outflows? 

You know, what's really interesting in the – the Platinum announcement came out and said Regal's walking away here. We've seen discussions with them. We're paying a special dividend, which was 20% of the share price at the time, and also said there's a review going on into the investment strategy. And at Platinum, it's been 10 years now, a very significant underperformance of indexes. They have pitched ever since I've known them. And you and I have had a lot of respect, well, for both of these businesses over a long time, to be honest. And the people have been generous with us when we were young. There's a lot of people from our time at Intelligent Investor that invested in the funds on the back of our belief in them. 

This whole podcast taking a step back for me is really trying to learn some lessons from this, but it's not any sort of joy to see what's been going on there. It's quite upsetting for me to see what's happened to the business. But how much do you think – my guess is here, there's a review into the strategy, we're not owning enough growth and tech stocks with too much value. You can probably write down that will be the day when that factor stops working as well as it has. But how much do you actually need to question your investment strategy and philosophy when you're going through difficult times? 

[0:14:40] GB: That's a tough one. I think Platinum in particular is a bit of a unique beast there. I mean, historically, they went through periods of underperformance and then they'd have these unbelievable years where they just absolutely killed it. I can't remember them off the top of my head. I have not looked closely at this fund for a long time, but they would take a bet on lately – or for the last decade or more, it's been Asian stocks have been a big part of their portfolio. They would have an alternative viewpoint and they would get a payoff year. And it might only come one year in three or one year in five, but they would put on significant outperformance in relatively short bursts is my memory of how that looked for Platinum. 

And again, we'll touch on this later, but this is a business you would not accuse. If one of the prerequisites out performance is doing something different, they have in the past at least consistently been different and try to be different and back their own viewpoint. It hasn't worked the last few years. You need to be right as well as different. Anyone else, I'd say they'll come back and say buy tech stocks and whatever. I'm not 100 % sure that's going to be the case here. Maybe that culture is died in world of value investing. And something has not been working. I think they've made is Asia the right place to put a big part of the blame here? 

[0:15:55] SJ: Well, I think it's that. And there is also just shorting of indexes. And the fund has historically been built to do most of its outperformance in down markets, and we just haven't had many of them, right? I think you're sitting here post some very strong years of market returns and everyone saying, "Well, this thing's now underperformed over 10 years. It's been 10 years of very strong equity market return." I think there is definitely the Asia and the value tilt in general. And then there's also the down-market protection that has been built into the product over long periods of time. 

[0:16:31] GB: And no down markets or insufficient down markets. 

[0:16:33] SJ: Insufficient, that's right. Yeah. And I think that's a difficult thing. That's probably, to some extent, almost picking the wrong benchmark or setting the product up in a way that you've convinced your client base that —. 

[0:16:46] GB: Yeah. That's issue. 

[0:16:46] SJ: —the index is the right thing where – 

[0:16:48] GB: Being contrarian is fine. But if a big chunk of your investor base aren’t actually wide contrarianly or aren't prepared to deal with these ups and downs, then you have a problem. 

[0:17:01] SJ: Yeah. And also, I mean, we've had our own reflection periods over the past few years and things go wrong. And for me, there's two really important things that you need to separate. I think you should always be thinking about what you need to change about your investment philosophy and strategy. And especially if you're running a funds management business that has got much bigger, it's fairly obvious to me that some things will need to change there. But it's this constant battle between keeping what has made you successful and your willingness to be different and being also willing to adapt and change. 

And I think there are some things about markets now and the role that's passive playing that you just have to accept as an active investor and even try and take advantage of where you can. It's a very difficult battle on that side of things. But for me, the really big one is if you look back over 10 years and you bought a business and today that business is trading at less than you bought it for 10 years ago, I would say even five years ago, and you're not sitting there saying the value of this thing has grown 50% or something over that period of time, you've got that actual business valuation wrong. And it's something that I've spent most of my time on is not necessarily just looking at the overarching fund returns, but going back, picking a point in time, looking at a portfolio and say, "Well, what happened here? We owned 25 stocks. Let's go through those 25. See what we think they're worth today." Forget what the market is pricing them at, but think about what we think they're worth today. 

And if we've got that wrong in terms of we owned a stock back then or we held a stock, it might have gone up a lot. That today is worth less than that price that we held it at or bought it at five years ago. Then that is definitely something that's worth some reflection on. How do we stop getting that right? And I think it actually does lead you to some bigger portfolio questions about the types of businesses that you want to own and how to value some of these better quality and growing businesses, right? 

I think anyone today would look at an alphabet and say, "If you're running a giant global fund, you should look back and say there were three or four opportunities over the past decade to buy that company at a really cheap price relative to the cash and earnings that it's generated." It was a value stock at various points in time. I don't know. Where have you landed on that in terms of what you keep and what you change? 

[0:19:17] GB: Yeah, it's a hard one. I mean, we've owned stocks that did nothing for three, even four years and then gave us really outsized returns. You do have to be – it's really hard to explain. But you have to be pigheaded enough at times to ignore the market, but also respectful that it might be right and you might be wrong. 

I think the only time that five years wouldn't reveal a mistake is you predicted the cash flows would grow and they have grown, but the multiple is just contracted a lot and unfairly. Then you've got to make the case why did it do that. But, okay, we've had a headwind for five years. We will get an outsize payout at some point if we're right. I mean, we've got stocks. We have a stock like that at the moment. But at some point, you have to recognize that the market's got it right and you were wrong. 

[0:20:09] SJ: And I would say, I mean, it must be 90% of situations, I reckon, within that five-year period. If your investment has gone wrong, you can probably look back at the old cashflow forecasts and 90% of the cases is you'll be wrong on the cashflow as well. You actually got the business valuation wrong. 

Alrighty, I'm going to bring in a voice that might be familiar to a few of our longer-term podcast listeners and old video watchers but hasn't been heard from a while. This is Chloe Stokes for a guest podcast appearance. And we're going to talk about investment philosophies and processes in general. And then Gareth, I'll drag you back to talk about the big question. What's the future of the active management industry? 

[0:20:48] GB: Hopefully, there's a small space in it for us. 

[BREAK] 

[0:20:51] ANNOUNCER: Stay tuned, we'll be back in just a sec. Are you a long-term investor with a passion for unloved bargains? So are we. Forager Funds is a contemporary value fund manager with a proven track record for finding opportunities in unlikely places. Through our Australian and international shares funds, investors have access to small and mid-size investments not accessible to many fund managers, in businesses that many investors likely haven't heard of. We have serious skin in the game too, meaning we invest right alongside our investors. 

For more information about our investments, visit foragerfunds.com. And if you like what you're hearing and what we're drinking, please like, subscribe, and pass it on. Thanks for tuning in. Now, back to the chat. 

[EPISODE CONTINUED] 

[0:21:34] SJ: Chloe Stokes, welcome back to the Stocks Neat podcast. 

[0:21:37] CS: Thank you for having me, Steve. 

[0:21:38] SJ: I had a client the other day asking me where you were. Is Chloe still working for Forager? I said, "Yeah, she's still here, but there's been a bit going on." And you've been a bit quiet about it. So you might as well fess up now and tell everyone what's been happening in your life. 

[0:21:51] CS: Where I've been and where I'm going. 

[0:21:52] SJ: Yes. 

[0:21:52] CS: So I took maternity leave about 18 months ago. I had my first baby, a little boy called Louie. I came back to work in July. And I didn't know it yet, but I was pregnant with my second baby. So I'm about to take another maternity leave at the end of this year. It's not how I would have planned it. I'm sure it's not that exciting for the rest of the business either, two maternity leaves in a row. But sometimes this is just how things turn out. 

[0:22:22] SJ: But you're wonderfully modern employer is over the moon about it and very supportive and doing everything we can to help. 

[0:22:29] CS: Yes. No, that is very true. 

[0:22:31] SJ: Now, honestly, we are very excited. And as a business, these are things that we want people to have good families and happy families and to assist with that as much as we can. I think it is very, very difficult in modern society. And it's not easy as a small business, but I think it is an industry where you can have a good family and a good family life and also a good job as well. The flexibility is possible, as we've seen. 

[0:22:58] CS: No, definitely. And you'll be pleased to see that I'm just getting it all out of the way at once. 

[0:23:06] SJ: Take the medicine. Gareth and I were just talking about investment processes and this whole Platinum. We're going to review our investment process and philosophy here. And I thought, as someone who had some time away from the business and came back, you might be well place to talk about some of these things. I mean, what are your thoughts on how long you give something that's not achieving the results that you want it to achieve before you think about changing it? 

[0:23:31] CS: I guess that depends on the magnitude of what not achieving looks like. I think if you have really significant underperformance for 12 months or so, that should be a big enough red flag that you need to look and reassess it. How much of that is a result of your strategy not being correct or you not abiding properly to your strategy? And even if the result of that review is to say that you've been doing everything right and it's just a lot of bad luck, I think a year of really significant underperformance is enough. 

Outside of that, I would say it really depends on an individual funds' investment horizon. If your time horizon is five years and your performance is not doing what you expected it to do over a three-year period, then it's probably something you need to look at. I don't think you can get right to the end of that time horizon and then have a look back and say, "Oh, it's not doing what we thought it would," you need to be a little bit more proactive than that in my opinion. 

[0:24:31] SJ: Yeah. And Gareth and I were talking as well just about the actual investment thesis you have versus the market price of the stock. And my experience has been even with all the volatility that we've had most investments over a five-year period anyway. If you look back in the share price has done nothing, it's usually because the business has done nothing or it's gone backwards. Or, yeah, it's just not delivering on some of those expectations. And we've had those in our portfolio, I think. And when we think about our own review of process and things, it really is focusing on those really clear investment thesis didn't work rather than trying to blame the markets and small cap underperformance. And I think those things all need to be taken into account, right? If you're sitting there, business is going great, share price hasn't moved, you can tick it off and say this is okay. More often than not, it's not actually the case. 

[0:25:24] CS: It's also a lot easier to see when it's not actually the case in hindsight, when there's kind of green shoots in an announcement that the market has taken negatively and then something amazing happens the next quarter, you look back and you're like, "Oh, it was so obvious that this is going to happen." But at the time, you're just as focused as everyone else on what was deemed by the market to be the key piece of information. It's a lot harder to be objective about those things, especially if you don't have a really kind of sturdy process in place that's telling you what exactly it is that you're looking for. 

[0:25:59] SJ: I think you're almost uniquely placed as someone who had a year out of the business and then came back in the middle of a much better performance period. And what are your thoughts on the work that we've done on our own investment philosophy? What was the same? What was different when you came back? Any insights that you have from outside the business that might help? 

[0:26:20] CS: I Think we've done a lot more work on process. I think that's something that we started probably around the time that I started. We've been doing work for kind of six or seven years. We've been constantly redefining what our investment thesis looks like? What needs to be covered? How it fits into the portfolio? What kind of ideas we do and we don't invest in? And how we update our investment thesis as well. 

I think the biggest change has been to that updating point. We've always had a process around every time we get a quarterly result, we update what our thoughts are on a stock. It's something we've done since I started. But the templates that we're using, the things we're making sure we're ticking off, how we're tying it back to the initial thesis, and kind of the forced tracking. We're putting everything in one spot. We have a big table where we can see what changes we've made to the thesis over the life of the investment. And that's a lot easier to kind of look at and say, "Hey, wait a second. We've actually changed our assumptions three or four times here in the past couple of years." Compared to if you had to go through a bunch of old documents. We would have documented those changes. But having a snapshot there that anyone in the team can look at even as a bit of an outsider to a particular stock and come in and say, "Why have we changed this thesis three or four times and we haven't had a bigger discussion around kind of why that might be." I think it's a lot harder now for things like that to slip through the cracks. 

[0:28:02] SJ: Especially when it's in the same direction, I think. 

[0:28:05] GB: Exactly. 

[0:28:05] SJ: If it's down a bit, up a bit, down a bit, up a bit, that's all fine. Or the macro environment is horrible and this business is going through a difficult patch. Also, understandable as well. But when it's a kind of expectations here for longer term growth or margins or whatever it is down four or five times in a row, then it's time to start asking questions on it. 

I just had one more question for you as well. We all get very involved and emotionally attached to stocks. Being outside the business and coming back, has that perspective helped or hindered in terms of, I guess, your current views on what's going to work and what's not working? What the best opportunities are? 

[0:28:42] CS: I actually couldn't believe how different my attachment level was to my stocks when I returned after kind of not being in the detail for 12 months. The subconscious bias that you have to want to continue to own something that you already own is something that we always talk about. We all know we have it. We discuss when it might be kind of rearing its head. But coming back and being able to actually have a fresh look at a stock, it feels more like you're doing that initial due diligence, even though you've owned the stock for a while. 

It was very clear to me just how strong that subconscious bias usually is. I found it so much easier coming back and looking at a couple of stocks that I hadn't looked at over three or four quarters and saying, "Maybe we shouldn't own this anymore. It's kind of not tracking to thesis." Where If I was here for each of the quarters when something small happened in the negative direction, it's very easy and it's human nature to try and justify that to yourself. 

That was actually the biggest learning for me coming back, just how strong that attachment is that you feel. And even if you don't think you're feeling it, you definitely are. And just having kind of 12 months not being right in the weeds, it changed everything completely from that perspective. I'm not saying I have no subconscious bias now. It's probably back. But when I come back again, I guess I'll be able to do that fresh review all over again. 

[0:30:11] SJ: Yeah. You talked about having a line in our table for every sort of update we do. It's almost being able to jump to the end of it straight away, right? And without all of the in-between, you say, "Well, wow, we had this expectation," and we're miles away from it just because you haven't looked at it in the interim period versus as it's happened slowly. And as the frogs in the boiling water that's getting warm slowly, you sort of come back and the water's hot rather than you've been sitting in there with your hand and it's incrementally got warmer and warmer over time. 

[0:30:40] CS: Exactly. That was a huge benefit just coming back and being able to have that objectivity that you do have when you're looking at a stock initially. The types of things that you would justify for something that you own, you would give a big haircut to a valuation if you didn't own the stock yet, most of the time. 

[0:30:57] SJ: Yeah, I even find that diligence piece around. And you've probably done it, right? Coming back to something. I haven't looked at this in ages. I need to do all of this work. When you're just updating and monitoring something, you don't necessarily go to the same level of reading the notes to the accounts or even reading the transcripts three times. It's just that, "Okay, this result was what I was hoping for, expecting. Or it's a little bit better or worse," and you move on quite quickly. Whereas when you first researched the stock, you went into all this detail and you spoke to experts and you talked to a bunch of people that you know that work in the industry, it's really important to keep doing that stuff all of the time as well. 

[0:31:29] CS: You can almost get too familiar with the stock. 

[0:31:31] SJ: So if you're too close and you need some perspective, have a baby. Moral of the story. Now, I actually find the same thing from holidays for me as well. If I go on a proper holiday, A, I get more creative. I come back and I have some good ideas. Usually, there's a couple of new things that come out of it. Just that bit of time away and perspective is really important as well. A great piece of advice there. 

Well, good luck for the next year, Chloe. We can't wait to have you back. But hope it all goes well. And I hope that two is no more difficult than one. 

[0:32:00] CS: I don't think that's possible. 

[0:32:00] SJ: Chloe's got the dream baby, by the way, everyone. 

[0:32:02] CS: Yeah, I'd one dream baby. I don't think anyone gets two. We will see. But I'm excited to be back. 

[0:32:09] SJ: All right. We'll get Gareth back on. Thanks for joining us, Chloe. 

[0:32:12] CS: Thanks for having me, Steve. 

[0:32:14] SJ: Welcome back, Gareth. Look, I'd say the demise of these two giants of the active management industry is only adding to the noise about the benefits of passive. And there's certainly a self-fulfilling element to it at the moment. CBA, which is now 10% of the ASX ordinary's index is trading at a growth multiple. 28 times earnings for a business that absolutely nobody, including its biggest fans, expect to grow at more than sort of GDP growth rates over future years. 

I mentioned this earlier, but the US is now more than 70% of the MSCI World Index. It's attracting most of the passive flows because most of the passive flows are going into that MSCI World index. A lot of people have been talking about a change and negative consequences for this trend from a long time. But what does all of this mean for the active management industry? 

[0:33:04] GB: I think what you've touched on there is that indexing an ETF world really accentuate winners and accentuate losers, right? And that process tends to run in train until it runs out of steam. And then there's often a violent short term or long term, a violent correction at the end of that. 

Our job, it's noteworthy that we don't own CBA in the Aussie fund. We do own a couple of European banks and English banks in our international fund because they have not been – because they've been on the nose for whatever reason, they have not been attracting that bid from index funds and ETFs. And so, they are quietly well-valued versus something like the CBA in Australia. 

[0:33:50] SJ: I mean, what would it be a third of the multiple maybe for the same sort of growth profile? Yeah. 

[0:33:55] GB: Yeah. I mean, maybe the growth profile is a little softer. But just really large dividend yield is going to – dividend and buyback yields going to shareholders much larger than the CBA. CBA is paying even including the benefit of franking credits. Yeah, it's chalk and cheese. 

[0:34:14] SJ: It's also just a function, I think, of those markets being from a passive flow perspective, not getting any flows, right? I think you'd look at it and say – 

[0:34:22] GB: It's sort of a feedback loop is the word, right? They're not getting flows because they're not performing. They're not performing because they're not getting flows. Those two things feed on each other for a long time, they can. 

[0:34:32] SJ: Yeah. And it feels to me, if anything, it's accelerating at the moment. And maybe these sorts of headlines are only contributing more to that. If you're sitting there, you've underperformed in Platinum fund for a long time, it's a perfectly logical thing to pull that money and say, "Well, I'm just going to put it in a passive fund and not make too many fees." 

[0:34:50] GB: I think thinking about that passive versus active world is really important. Vanguard started this process a long time ago, but it's only in the recent decades where it's become a bigger and bigger part of markets and is starting to move markets, passive investing. And what we've seen is the old active models where you would have some pretty big funds management businesses, I would say stuck in the middle here that they ran close at index products. They charged active fees. They made a killing doing it and they didn't serve their clients particularly well. That model has been killed off over the last – probably over the last 20 years. It's not been a really recent thing that AMPs and the BTs of the world came under pressure a long time ago. That is now spreading, right? It's moving to you can buy an index for small cap tech. You can buy it for emerging markets. You can buy it for all sorts of things. So you can cover all sorts of actors quite easily with an ETF now. 

Someone that's just selling exposure to that without providing a differentiated product at an active management fee charge is getting hurt. We're seeing that maybe in the Magellans of the world that have a quality – call it a quality basket of stocks that you can buy a quality fund quite easily. 

[0:36:14] SJ: Yeah. QQQ. 

[0:36:15] GB: They're struggling on that front. And so, I think it's getting more and more differentiated that ETF and index world. And therefore, it's affecting more and more active fund managers to the point where you really need a highly differentiated product now to survive and to have any reasonable prospect of outperforming, which is why you should survive. 

[0:36:38] SJ: Yeah. I think, interestingly, there is still. And maybe it's even more evidence that at the smaller end of the market there is a lot of value that can be added. I was just looking at our Aussie fund on Morningstar the other day, and there are 105, I think, funds in our category on Morningstar. Small and mid-cap Australian stocks. And the category in aggregate has performed 3% per annum better than the small-cap index over the past 10 years. 

Now, it's been a very weak period for the index and I think that is a particularly bad index. It's got a lot of very small mining companies that just not owning them adds some value. But I think it is a sign that, at that part of the market, there is a lot more value to be added than there is in giant, very well-covered blue-chip companies. And I think you actually had some stats on – or was it advice from someone on when to think about allocating the active versus – 

[0:37:42] GB: I'm sure I've mentioned this on a podcast before, but David Swenson, he's passed away relatively recently, but he was the CIO of the Yale Endowment Fund. And here's the guy that really revolutionized that whole industry. He came in, took away sort of a lot of active management in bonds and equities and outsourced that to ETFs. And then became highly active in forestry and a whole bunch of alternative asset classes. 

His theory around there, which I thought was really well struck, was there's a couple of things you're looking for. If it's really difficult for the median fund to – I think it was the median or even a top quartile fund to outperform the asset class itself. Because there's no opportunity for actually alpha in it. And so, all you're doing is incurring the high-fee load and you will underperform the index in that sector by your fee load. Bonds is a great example. It's really, really hard for a bond fund to outperform. When one does, it's a fluke. It happens one year and and they don't do it again for 10 years. In those spaces, use indices, use passive. 

And then the other thing you're looking for is the longevity of the top quartile performers. So are they in the top quartile this year? Were they in it last year and the year before, and the year before? That's an indication of something that it might have longevity. That is an area where you might consider paying up for active rather than using the passive alternative. 

[0:39:12] SJ: Yeah, right. Instead of the specific fund even necessarily, it is an asset class where the outperformance has been consistent rather than – 

[0:39:18] GB: That's how it's been analyzed. Correct. So they've moved bonds passive first. And they moved blue chip equities next. And they kept small-cap US equities and maybe all-cap international because there were still inefficiencies in there. And it's been a story of them slowly over decades moving more and more of the money in those bases to passive. Whereas in something like forestry, at least in theory and I think in practice as well, they've proven that good management matters. You pay for it then. And that's when you use active management. 

[0:39:56] SJ: People will know that I've been a big fan of index funds over the years. I think our product complements a core portfolio of low-cost strategies really well. I do think there's a momentum about this that there's a risk here of a good thing becoming a dangerous thing that it's creating bigger and bigger distortions. 

[0:40:20] GB: It's becoming the market, right? 

[0:40:22] SJ: Well, I think for anyone that's using passive, it's just really have a look at what's in the fund. Have a look at where the waiting is it getting to. If you're looking at MSCI World and it's now 75% US and you go, "Okay, this country is 30% of world GDP and it's 75% of the market," you can just even restructure your own passive exposures to be a little bit. I think diversification is your friend in passive. You do not want to be taking very big concentrated portfolio bets. That's the whole point of the strategy. Diversify. Keep costs low. 

To the extent things are getting out of whack, just think about how you might be able to rebalance your own passive exposure there to be a little bit more balanced and diversified. You might be able to do your own S&P 500 ETF alongside some UK and Europe exposure and some Asian exposure that you yourself blend together into something that's back to 50, 55% US exposure, even here in Australia. I haven't looked at it more recently. But there was a equal-weighted ASX index. It's a good way of getting around the massive exposures – 

[0:41:25] GB: Not sure what's happened to them, but there have been people experimenting with value-weighted as well. Instead of just having the biggest companies dominate the ATF, it was the cheapest companies dominating the ATF. 

[0:41:37] SJ: I can't imagine that's going very well. 

[0:41:41] GB: Oh, for now. 

[0:41:41] SJ: And look, I'd be really, really careful of any of these theme-based ETFs. You can almost write down the top of the market for a particular theme the day they come out with an ETF that replicates it. And again, I think you're defeating the purpose of using the products, which is recognize that outperforming is really, really hard keeping costs low. And then people want to go and buy cybersecurity ETFs and all sorts of crazy products that the track record has record has been woeful on. 

[0:42:07] GB: Again, it's mainly about trying to sell something with a higher fee structure. And I think this all then plays into more into my thesis around what's happening in markets, which it's harder to find pockets for outperforming points in time. There are more points in time where things are fairly-valued than cheap now than there was 20 or 30 years ago. But the swings to the extremes are probably more significant than they were. And more that the investor base is passive in a stock, the more that's going to happen. It's just going to be dictated by flows. And sometimes they're going to be very ignorant to the value on offer. Day-to-day, that is not something you can take advantage. But every now and then, it's something you can take advantage of and build outperformance around that. 

[0:42:54] SJ: Yeah. And it feels like it's almost even more regular to me than it was used to have to wait 10 years. And now I think these passive flows are so cyclical on a fairly short-term cycle that you get your opportunity pretty regularly if you're willing to wait for it. I think for those people out there that are looking for an active fund, I hope you've picked up a bit out of today's podcast in terms of some of the things to look for. 

I always say to people, and you can get from our annual performance reports, you can ask other fund managers for it. Okay, your track record is good. Show me the top 10 stocks that contributed to your performance over that period of time. And just have a look whether that could actually be replicated at the size that the fund is at. I think it's the thing that people miss most that is a huge limiting factor on fund performance. 

[0:43:47] GB: Maybe it's worth talking about your thoughts about that for our funds. 

[0:43:49] SJ: In terms of where we can go or – 

[0:43:52] GB: Yeah. And I guess what you intend to do about it. Of course, we'd like to be managing 20 billion if we could do a good job and enjoy our lives and make money for people. But that's probably not going to happen. I guess, what's the plan around that? 

[0:44:06] SJ: Well, I think certainly in the Aussie fund, it's going to be capacity constrained much sooner than the international. We said 200 million back when we listed the Aussie fund in 2016. It's probably 250. Now, I think we're having a huge amount of success with these companies that are 2 and 300 million market cap that are growing to the size where other fund managers can then get interested in them. And then ultimately into the index and you get passive flows into that RPM global recently on that front. Gentrack's gone into that category. 

For us, I think that $200 to $300 million company is a really important place for us. And we want to have decent weightings in it. So a similar size, I think, for our fund is the right point for us to, again, close it. That's still a ways away yet. Things have been going well and we're very happy on the redemption side of things post the listing. 

[0:44:59] GB: Just to clarify there for people, close, it means closer to new money. It's not a step you see a lot in the funds management world, but that is our intention. 

[0:45:06] SJ: Yeah. And I think in Aussie small-caps, you've seen – I mentioned the magnitude of the outperformance earlier. More of them are closed. Most of the ones that have done really well have closed because they have the same capacity constraints. 

[0:45:19] GB: And that's how you stay good, right? I guess that's the whole point we're trying to make here today. 

[0:45:24] SJ: Look, I think national one, we've said for a long time less than a billion. I think we've still got some proving up to do. And again, it's not something that's going to happen anytime soon in terms of the levels of flows that we are seeing. It's a nice size at the moment for us still to be able to do that significantly sub a billion-market cap. And we've done really well across different market cap ranges. And that five to 10 billion even US is still a nice space. I think that is where you're really getting those passive flow impacts on individual stocks quite regularly. 

But I would still like to see us doing a lot in the sub-one-billion market cap. And we've had some of our biggest successes in terms of contributions in that part of it. So it needs to stay small as well. And part of it for me is just enjoyment of life as well. 

[0:46:12] GB: Yeah. For me, I'm thinking that more immediate cap is five hundred million rather than a billion. But I think we need to prove ourselves at every step. 

[0:46:20] SJ: Yeah. And I think there are pockets of the world that we have got narrower and narrower. And I think it's helped outperformance just sticking to things that we know and have experience at as individuals. I do think there are pockets of the world and industries and types of businesses that we could do really well in if we had that expertise in the team. So I think you're dead right. That's probably the right number for the current infrastructure that we have. But I do think – 

[0:46:45] GB: There's one more to the fund, perhaps. 

[0:46:47] SJ: Well, if you think that we think we can run 200 to 250 here in Australia alone, which is 3% of the world market or something. If we can replicate the edge is what I'm trying to say. If you can replicate the edge. And that is not an easy thing to do. But there are people out there doing really good jobs in different markets that we're basically not even looking at because we don't have the expertise and experience there. 

Hope that's been helpful, everyone. And I hope you're having a wonderful Christmas break while you're listening to this. We'll be out with our quarterly reports in January. And we've got a webinar coming up as well. So tune into that. And as always, send us an email. Give us a call. Give us any suggestions you have for future podcasts. Thanks for tuning in. 

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