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Legg Mason IF Royce US Smaller Companies Fund - research update

Investments can go down as well as up so there is always a danger that you could get back less than you invest. Nothing here is personalised advice, if unsure you should seek advice.

The question of how long to hold a poor performing fund is one every investor will have to tackle at some point. It’s not easy to answer. All fund managers experience periods of poor performance. When they do it’s important to not make hasty decisions and instead look at the reasons behind the lacklustre returns, putting them in the context of the manager’s longer-term track record.

The Legg Mason IF Royce US Smaller Companies Fund, managed by Lauren Romeo, initially recovered well from the 2008 financial crisis, delivering strong returns during 2009. Since then the fund has not performed well and has lagged the Russell 2000 Index of US smaller companies significantly.

The chart below shows the fund’s performance since 2010. Over this period it has grown by 53%, delivering half the 106% return of the Russell 2000 Index. Please remember past performance is not a guide to the future.

Performance since 2010

Performance graph

Past performance is not a guide to the future. Source: Lipper IM to 04/01/2016

Why has performance been so poor?

When the financial crisis hit in 2008 governments and central banks across the developed world slashed interest rates to near zero. Along with other measures, such as quantitative easing, this was designed to stimulate economic growth, partly by encouraging banks to lend and investors to buy shares and bonds issued by companies, rather than hoard cash.

Low interest rates meant companies could borrow cheaply. There was a ready supply of money available as investors seeking income were willing to lend to companies via the bond market, where the interest payments available were far superior to those on cash deposits.

The result of this is that highly-indebted companies that might otherwise have struggled have been able to easily service their debts and borrow more money. The money borrowed can be put to use increasing production or marketing, for example, in an effort to boost sales and profits.

When economic growth is robust and interest rates are low, high debt (or financial leverage) can be an advantage, and financially-leveraged businesses have generally performed well over the past few years.

However, such businesses can quickly become overrun by debt if economic growth falters or interest rates rise and the business cannot generate enough cash to maintain interest payments. The inherent uncertainty involved in investing in financially-leveraged business means Lauren Romeo tends not to own them and has missed out on the gains.

The manager also tends to avoid companies which have no revenues, are unprofitable, or which have unproven business models. This rules out many companies in the healthcare and biotechnology sector, for example, which have also performed well in recent years.

Along with some exposure to gold mining companies (which have now been sold) and energy companies, which have struggled in the face of lower commodity prices, these factors have been responsible for much of the poor performance. Our analysis also suggests poor stock selection has detracted from returns.

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Why is the fund still on the Wealth 150?

Lauren Romeo has the support of a well-resourced team at Royce, which includes the company’s founder Chuck Royce. They have been investing in US smaller companies using a consistent, long-term approach since the 1970s. We have data on Royce & Associates’ track record since October 1993 and this is shown in the chart below.

Royce & Associates track record

Track record chart

Source: HL. Track record comprises: Royce Premier Fund (October 1993 to October 2003), Royce 100 Fund (November 2003 to March 2004), Legg Mason IF Royce US Smaller Companies Fund (April 2004 to present). Past performance is not a guide to the future.

The team looks for companies in good financial health with a history of earning good returns on the capital invested in the business. They look to invest when the company is out of favour and its prospects are being under appreciated by other investors.

We believe the team has a sensible approach and do not think their process is broken. Lauren Romeo believes that now interest rates have started to rise in the US, lower-quality, highly-indebted businesses could start to struggle and investors could refocus on higher-quality businesses with sound finances.

Indeed, during brief periods when investors have become concerned over the prospects for the US stock market in recent years higher-quality companies have performed better, benefiting the fund. However, the concern has never lasted long and improvements have not been sustained.

In addition to rising interest rates benefiting the companies she invests in, Lauren Romeo also expects healthy economic growth to provide a boost to companies which thrive in a stronger environment such as those in the industrial, information technology, consumer discretionary, and materials sectors. The fund therefore retains its bias to these areas.

This fund invests in smaller companies which can be more volatile so is aimed at more sophisticated investors. It can also use derivatives which if used also increases risk.

Our view on this fund

We have been disappointed by the fund’s performance over the past few years, but we appreciate active managers can experience long periods when their style is out of favour and returns are poor. Now the environment has changed to one the manager believes is more supportive of her process we expect to see an improvement in performance. This, taken alongside the team’s long-term track record means we are willing to give the fund more time to improve. We will monitor the fund closely over the coming year and will inform investors if our views change.

In addition, we recently secured an additional discount on this fund’s ongoing charges. Hargreaves Lansdown clients now benefit from a 0.18% saving on the funds’ 0.98% ongoing fund charge, bringing the net ongoing charge down to 0.8% a year from 0.94% previously. The Vantage charge of up to 0.45% per annum also applies. View our charges.

Find out more about this fund including how to invest

Please read the key features/key investor information document in addition to the information above.

Important information - Please remember the value of investments, and any income from them, can fall as well as rise so you could get back less than you invest. This article is provided to help you make your own investment decisions, it is not advice. If you are unsure of the suitability of an investment for your circumstances please seek advice. No news or research item is a personal recommendation to deal.

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