In the 1990s, when Russian markets were opening up to a brave few foreign investors, East Capital founder Peter Elam Hakansson had a foolproof way of rooting out the good companies from the bad. He visited their offices in winter to check if they could afford heating.

In the early years of market capitalism in Russia it was almost impossible to find reliable information about companies from earnings reports, so those investors prepared to travel to run-down Siberian cities in sub-zero temperatures had an immediate advantage. The proof is in the 2,098% return Stockholm-based East Capital’s first Russia-focused stock fund made in the last decade, about a third more than the average of peer funds tracked by Morningstar.

Stockholm-based East Capital’s first Russia-focused stock fund has returned 2,098% in the first decade of the millennium.
Stockholm-based East Capital’s first Russia-focused stock fund has returned 2,098% in the first decade of the millennium. Bloomberg News

The anecdote may seem redundant in an age where information can be obtained at the click of a mouse and money managers are increasingly being bested by funds that passively track indexes. But Hakansson says investors struggling to demonstrate their value in the face of growing competition from ETFs would do well to heed the lessons he learned investing in Russia.

“Being an active owner takes both time and resources and that will be one of the best differentiating factors for successful fund managers,” Hakansson said. “We always want to see how companies are run. The most important thing is also to meet the owner. We always try to get to know who is behind the company.”

The strategy has helped East Capital’s $427 million fund take an 11 percentage-point lead over the benchmark in the past year by stripping down exposure to Russian energy companies. These make up almost half of the key Russian stock index and have suffered amid a drop in oil prices.

A CHORUS OF COMMENTATORS
The $16 trillion mutual fund industry is facing one of the biggest shakeups in its more than 90-year history as investors pull out cash in favor of passively managed portfolios. Flows out of active mutual funds and into passive funds likely approached $500 billion in the first half of 2017, almost double any other start to a year, according to Bloomberg Intelligence.

Hakansson is joining a chorus of commentators defending the role of hands-on asset managers. Investors including Vanguard CEO Bill McNabb, who oversees the world’s biggest ETFs, say active fund managers can succeed if they lower fees and demonstrate a clear investment strategy.

The “exodus” is mainly hitting “high-priced benchmark huggers,” Ben Johnson, a director of ETF research at fund data provider Morningstar, said in a report. “Taking on more active risk is the only way that many managers can possibly justify their current fee levels.”

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Worst mutual fund performance compared to benchmarks
Active management gets a black eye when funds can’t keep pace with indexes, especially when the shortfalls aren’t short-term.

The case for active funds is even stronger in emerging markets, where indexes are less liquid and money managers have more flexibility than their passive peers to rapidly shift exposures between sectors and countries, according to a research report by Van Eck Associates.

East Capital’s Hakansson, whose various Russia-focused funds charge a 2% management fee and have about $1.3 billion under management, has been increasing holdings in consumer-oriented stocks that used a recent economic downturn to increase market share.

According to Bloomberg data, his biggest holding is London-listed X5 Retail Group and he holds an overweight position in Aeroflot, Russia’s biggest airline, which makes up 1% of the Russian stock index and has surged 41% to a record high this year.

“The best way to compete is to show consistent alpha compared to the index,” Hakansson said. “If you buy an index fund you will never beat the benchmark.”

Bloomberg News