The Fairtree Flexible Income Plus Prescient fund has maintained a remarkably consistent record since it was launched in June 2013.
Whether measuring its performance over one year, two years, three years, five years, seven years or 10 years, the fund is one of the top 20% in its category. It has never had a negative return over any calendar year, and its average gain of 9.1% per year since it started is higher than the return from the JSE Top 40 over that period.
The co-managers of the fund, Paul Crawford and Louis Antelme, have also achieved this with very low levels of volatility. The fund has never been down more than -1.5% from any previous high, and for 93.7% of the months it has been running, it has made a positive return.
The way this has been achieved, according to Crawford, is by employing one of the most important, and often misunderstood, principles in investing.
‘We inherently believe that the only free lunch you get in investing is diversification,’ Crawford says. ‘The broader the portfolio, the more certainty you achieve. And that has nothing to do with a personal preference. It is mathematical fact.’
The fund invests in bonds – or credit – issued by companies both locally and, predominantly, in Europe. In other words, it is effectively lending money to those companies and earning excess interest payments from them.
Currently, it holds the debt of over 400 different businesses.
What some investors may find disconcerting, is that almost all of those companies are rated below what is called ‘investment grade’. In other words, the credit ratings agencies like Moody’s and S&P think they have a higher chance of defaulting and not paying back what they owe.
As Crawford explains, however, the returns the fund is able to generate is precisely because of this concern.
‘There are abnormal returns to credit because people are afraid of catastrophic loss,’ he says. ‘Companies can, and do, default. We see those defaults quite often.
‘But there’s very little difference between investing in credit and what an insurance company does. If you pay a premium for insurance, you are one of thousands of clients paying premiums to that insurance company. Every so often, someone’s car is stolen, and that insurance company has to pay out. But they still make money because amount they collect from the portfolio of premiums is more than they have to pay out.’
Similarly, the Fairtree Flexible Income Plus Prescient fund is receiving regular interest payments from all of the hundreds of bonds in the portfolio. Every so often, one of the companies it invests in will fail, and that investment, or a portion of that investment, will be lost.
‘But what we earn from all of the premiums we get is more than we lose,’ Crawford says. ‘Importantly, this approach only works with an incredibly well diversified portfolio.’
If the fund only invested in ten different companies, for example, and one of them went bankrupt, it would lose 10%. But with investments in over 400 different companies, a default by one of them will be a loss of only around 0.25%.
‘Credit is risky if you run an ill-managed portfolio,’ Crawford says. ‘But just like an insurance company wants as broad a client base as possible so that if someone makes a big claim that won’t blow everything up, a well-run credit portfolio diversifies the risk of an individual loss away.’
He adds that this is just as true for banks. Nobody is worried about depositing their money with a bank, even though they know that it will have hundreds of customers who will borrow money and not pay it back.
That’s because everyone is aware that the bank has so many customers, that the relatively small number of those that default will not wipe that bank out.
‘This fund was specifically set up for a particular client in mind,’ Crawford says. ‘We wanted to generate a return of 2% to 3% ahead of cash, with low volatility. The portfolio has been doing that for over a decade.
‘We have had a number of defaults over that time. But those are all in the numbers. Those losses have been small, and so the fund has been able to keep delivering what it says it will.’
And while it may seem like managing a portfolio in this way shows a lack of conviction, Crawford believes this is precisely the point.
‘You shouldn’t have to have to watch what your fund manager is doing every day,’ he says. ‘We should be under the radar, chipping away, producing returns.
‘I have made many investment mistakes in my life, and the biggest ones were on investments I felt most strongly about. People shouldn’t act with conviction because it makes them believe they are the smartest people in the room and that’s probably when they do take risks that they shouldn’t. Over confidence, or high levels of conviction, should certainly raise a red flag to investors.’
