VT Downing Fox Funds Investment Letter Q2 2024

Not all advisers are equal. What separates the best from the rest?

“In Eastern Bloc countries under communism; brands were considered un-Marxist, so bread was simply labelled ‘bread’. Customers had no idea who had made it or whom to blame if it arrived full of maggots, and couldn’t avoid that make in future if it did, because all bread packaging looked the same…

I recently met a woman who lived under communism in Romania. A particular chocolate bar in that country was manufactured in three different factories, but the production differed so widely that they effectively produced three entirely different qualities of chocolate under the same brand name.

By folding back the wrapper, one could see a code that denoted, presumably for reasons of safety, which of the three factories had produced that particular bar. My friend, a young girl at the time, was under strict instructions from her mother only to buy this chocolate bar if the letter ‘B’ was displayed under the fold in the wrapper; if either of the other two letters were displayed, she wasn’t to buy it at all.”

That’s a quote from Rory Sutherland’s excellent book ‘Alchemy’. He’s highlighting the power of brands, but it’s useful to illustrate the concept of quality too. Specifically; why are a few products and services so much better than their competitors?

When I heard the Romanian chocolate story, my brain – as it often does – wanted to know why Factory B’s chocolate was so superior to the other two.

I can only speculate, but I suspect it was because Factories A & C were run by people who wangled themselves a higher-status job through political means, whereas Factory B was run by someone who cared about chocolate.

I’m imagining a Wonka-style character (without the flamboyant outfits - too unMarxist) who, despite there being no financial incentive to do so, can’t help but obsess about the quality of chocolate Factory B produces.

I think this factor – caring – is important to isolate. Because in any industry, not least financial advice, being naturally inclined to care about your product is a giant advantage. If you think of a product or service you currently love¹, I’d bet it’s made by someone who obsesses over it (probably to the point where it really annoys their spouse).

To be clear, exactly what they care about matters too. There’s no shortage of entrepreneurs who care primarily about making money and are good at that too. But their product is rarely loved by their customers. Whereas those who care first about the quality of the product end up being the best: They make decent money too, but no one begrudges them that as their customers love their product.

Let’s call these ‘Factory-B’ types². Why do they have such an advantage over competitors?

Well, you can’t choose what you care about. Not deep down. And it’s a sad truth that few people end up in a career that intertwines with their soul. Most end up in a job that, at best, they can force themselves to care about while doing it or, at worst, about which they don’t give a damn. When their workday ends, it’s a relief to stop thinking about it - they can return to something they do care about instead.

But not so Factory-B types: In the financial advice world, they’re the ones who drive home pondering tax planning, who mull over risk profiling in the shower, and can spend a two-hour dog walk thinking of nothing but platform choice. They’re driven to learn – on their own time - about esoterica such as behavioural finance, the psychology of managing staff, or the intricacies of double-entry bookkeeping, all because they believe they might make their service just 1% better.

And guess what? These things do make their service 1% better. Over and over again. So, eventually, they’re not just 1% better, they’re 100% better. If you’re a customer looking for a financial adviser, it’s these types– the Factory-B advisers – you want to find and cling onto.

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Turns out it’s simple: Make a high-quality product. One that Factory-B advisers will recognise as a tool that could make their service a few per cent better. That way they’ll end up finding you.

So, if you’ll forgive me, I’ll explain why I think the VT Downing Fox Funds represent a high-quality tool for advisers, and how – particularly at the current point in the market cycle - they may help make an outstanding advice business just that little bit more resilient to what lies ahead.

If you can’t beat ‘em…

I’m a true believer in active fund management, that much should be clear. This means that my natural nemesis has been the pioneer of passive management; Vanguard. So much so that, go back 15 years, and you’d have found me regularly cursing their name.

But not anymore.

I’ve mellowed over the years. I now concede their products have done a great deal of good for a lot of people - perhaps more than any financial product in history. I ‘get’ why so many advisers recommend them, and why people happily hold their funds.

And I can see now that Vanguard’s founder, Jack Bogle, was a classic Factory-B man, which is why their products are so good: Back in the 1970s he came up with a great idea, fought to get it launched, then continued to improve it, 1% by 1%, until here we are today. I have huge respect for him.

In business as in sports, when you’re up against a great competitor, it pays to study them. Where are they strong? Can you learn from that? And where are they weaker? Could that be an opportunity?

Read the press and you’d think Vanguard’s killer app is their low charges. But while that’s important, it’s not the whole truth. Their other key strength, arguably the more important one, is that their products are reliable: If you buy their US market tracker today, you can be sure that in five-, ten- or twenty years, it will still be a US market tracker. It won’t become active. It won’t switch to tracking the China market. And it won’t randomly decide to replace half its equities with cash.

It's this reliability that makes their products easy for advisers to use as part of a long-term financial plan, and therefore easy to recommend. It’s also, along with their simplicity, what makes it easy for end investors to hold onto them. Conversely, flibbertigibbeting between markets/styles/asset classes, is what complicates other portfolio products, often causing them to misfire. This makes them difficult to use in a financial plan, and harder to hold too.

I respect this reliability. If we want Downing Fox to be a first-class tool for first-class advisers – which we do - we need to recognise this and match it. It’s why we’ve hard-wired similar features into the Downing Fox funds.

So, like Vanguard’s mixed-asset range, we’ve committed not just to fixed equity exposures in the funds’ prospectus (the legal document that sets out what the fund can and can’t do), but have put them front and centre in their names too (we offer 40%, 60%, 80% and 100% equity versions).

We also don’t make dramatic flips between geographies and investment styles (you may have heard us talk about our ‘Unheroic Journey’; which commits us to a permanent balance between ‘value’ and ‘growth’).

Finally, equal - but opposite – to Vanguard’s commitment to market tracking⁴, we have promised, via our funds’ prospectus, to hold only actively -managed funds within our equity exposures.

This is, by design, the biggest difference between our funds and the Vanguard equivalents. Which makes sense: Finding great active funds is our chief expertise, so our products should succeed (or fail) on that factor, not something else.

And that’s the big idea. We offer a product we think will match Vanguard on commitment and reliability, but is markedly different in what it holds. This gives advisers another genuinely different, reliable, reasonably-priced tool with which to plan for their clients.

And not a moment too soon: We believe the naturally different exposure within the Downing Fox funds could help to protect an advice business against perhaps the biggest risk brewing in clients’ portfolios in 2024.

What is that risk? Read on.

The bigger they are…

Let’s start with a game of Spot the Difference. On the left is the style chart for the Downing Fox equity portfolio, and on the right is Vanguard’s Life Strategy equivalent. Each circle shows a fund holding within each of our respective portfolios (both are ‘funds of funds’), and the triangle shows what they add up to.

If you’re not familiar with these boxes, the higher the circle/triangle, the larger the companies it owns. The further left it sits the more deeply it follows the ‘value’ investment style, and the further right the more it follows a ‘growth’ style.

You can see that both are naturally balanced between styles, but Vanguard’s portfolio is skewed towards mega-cap companies while Downing Fox has more exposure to small- and mid-sized companies. This is a natural feature of what we both do.

Vanguard tracks the market, and the market is naturally dominated by giant companies. If you want to offer the cheapest possible product, you need to run it on a huge scale, so it has to have this exposure to the market’s largest constituents.

Whereas we hold active managers, and we want them to have the freedom to go where they find the best opportunities. They’re as likely to find a small company that can double its share price they are a large one⁵, so it’s natural that our portfolio sits lower down the market-cap scale. This is not a temporary feature for us – our portfolios will always look this way.

Here are the facts we can take from this:

• - If your clients only hold the Vanguard fund, their investment outcome will be dictated by the performance of large- and mega-cap equities.
• - If your clients hold only the Downing Fox fund, their investment outcome will be dictated by what happens to the performance of the average-sized company⁶.

This brings us to the big risk I mentioned earlier: Large companies have performed well for a long time, which has helped market-weighted passive funds like Vanguard’s to perform well too. If large companies were to perform badly for a long time, then market-weighted passive funds would perform badly too. If all your clients hold are market-weighted trackers, they won’t enjoy this.

Is this likely? And if large caps do badly, won’t everything else too?

Good questions. There’s no definitive answer on anything involving the future, but a similar episode in history suggests that a large-cap downturn is at least a meaningful risk, and that other parts of the market can hold up fairly well while large-caps go through the doldrums.

Alex, my co-manager, has done a deep dive on this - I’d encourage you to have a read here. But I’ve pinched a couple of charts from it to quickly illustrate my point.

The first shows this historical episode. On the left is the three-year period to the end of 1999, and on the right is the last three years. Both look similar in so far as the world’s fifty largest companies have raced away (blue line), which has dragged up the performance of the global tracker (orange line). Conversely, the Aberforth fund (green line), which we’re using as a proxy for the opposite of what’s been driving markets (anything that’s: domestic - not international; value - not growth; and small-cap - not large), has looked stagnant.

While I’d never claim conditions are identical to 2000, I don’t think it’s crazy to draw parallels to what we’re seeing today (you are, of course, free to disagree).

The next chart shows what happened in the seven years following that period:

The world’s fifty biggest companies lost half their value over the following three years and were still underwater after seven. Their influence on the global index was so huge that it dragged down global trackers by a similar amount, meaning an index fund only broke even after seven years of waiting.

And in case you think it was all faddy companies like Pets.com that did the plummeting, note that the world’s largest company at the time was Microsoft. It fully joined in with the mega-cap mega-slump, partly because excitement about the new-fangled internet had made its shares too expensive, and partly because competition and anti-trust proceedings hit its prospects.

This is the risk I’m highlighting. If you think your clients were upset because falling bond values meant they made nothing over the last three years, imagine how they’ll feel about another seven years of that caused by falling equities.

Finally, you can see how Aberforth’s small-cap UK value fund performed after 2000: Contrary to all expectations, it held up well in the bear market, then made stellar returns as conditions improved. These conditions created a golden period in which great active managers like Anthony Bolton (manager of the Fidelity Special Situations Fund) became household names on account of avoiding the over-priced mega caps that killed the wider market’s returns.

Our portfolios are full of funds that are managed like this. It’s what we hunt for (Factory-B fund managers, in other words). And rather than being worried about our future returns on account of high valuations, we’re excited because, in our part of the market, valuations are looking pretty damned good.

So, to tie it all up, when I look at an excellent product like Vanguard’s weak points, this – its permanent exposure to mega-caps regardless of valuations - is one of them⁷. For the Factory-B adviser, therefore, we think adding our portfolio into a well-considered CIP could provide a natural hedge against this weakness, helping to shore you up against a repeat of the 2000 to 2007 experience.

That’s all.

Naturally, we have more on this. And more on plenty of other things too. (What can I say? We’re obsessed). If you’d like to see any of it, drop us a line, we’re always happy to talk.

Good luck out there (and avoid the bad chocolate – it’s not worth the calories).

Simon Evan-Cook

Fund Manager, VT Downing Fox Funds

Learn more about the VT Downing Fox Funds

References:

¹ Like the butcher in my village. If he can’t find a farmer that produces a particular meat to a high enough standard, he starts rearing that animal himself. All of his meat is delicious, and reasonably priced too. And no, I’m not telling you which butcher; the queue’s long enough as it is.

² To clarify, being a naturally-inclined-to-care Factory-B type is necessary, but not by itself sufficient, for greatness. You also need some level of aptitude (as my obsessive-but-futile attempts to become good at golf attest).

³ As does, tellingly, the endlessly patient Mrs Evan-Cook.

⁴ They’re committed to passive in these particular products. It’s a lesser-known fact that Vanguard is also a massive active manager. Like us, they’re committed to finding only genuinely active, excellent fund managers, then charging a reasonable price for their services. But unlike us, their giant scale mostly restricts them to active large-cap funds.

⁵ On another day I’d argue they’re more likely to find winners among small caps, but we’ll park that for now.

⁶ The point of using active managers is to do better than that, but again we’ll leave that for another day.

⁷ The other big potential weak spot is that they have a longer-duration bond portfolio, which can become risky if bond yields fall too low before an inflationary surprise. This hard-wired position had helped over the life of their funds until 2022, when longer-duration bonds were torpedoed by an inflationary surprise. If you want to know how we countered this particular risk for advisers – which we did – give us a shout.

Risk warning

Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing available from Downing LLP or from the ACD, Valu-Trac; your attention is drawn to the risk, fees and taxation factors contained therein. Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested.  

This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. This document contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.