1. From Model T
    to Model 3

    ACTIVE MANAGEMENT IN US EQUITIES

    Baillie Gifford’s US Equities Team. Third Quarter 2017
  2. Investors should carefully consider the objectives, risks, charges and expenses of the fund before investing. This information and other information about the Fund can be found in the prospectus and summary prospectus. For a prospectus or summary prospectus please visit our website at www.bailliegifford.com/usmutualfund/usequitygrowthfund. Please carefully read the Fund’s prospectus and related documents before investing. Securities are offered through Baillie Gifford Funds Services LLC, an affiliate of Baillie Gifford Overseas Limited and a member of FINRA.

    This paper was originally written in 2017. This version was issued in August 2019.

  3. Baillie Gifford has been investing in US innovation for over 100 years. Our first investment was in the booming rubber industry, which grew on the back of increased demand for tyres as the Model T Ford took the US by storm in 1909.
  4. Today we are excited by the next leap in mass market transport: Tesla’s Model 3 electric car. US companies have been the bedrock of outperformance in the firm’s largest asset class, global equities. This amazing country is the innovation capital of the world. As our US equity portfolio approaches its 20 year anniversary, we are more excited now than we have ever been about US companies. We will therefore take the opportunity to reflect upon what it means to be a truly active long-term US growth investor and why this matters. We will also discuss what will potentially drive outstanding long-term returns over the coming years.

     

  5. Why are people giving up on active US Equities?

    Not everyone shares our optimism. US equities are witnessing significant flows away from active managers, a group which has struggled to make the case for its own existence. Generally-poor relative returns and high fees have drawn investors towards passive approaches. For example, over the past year, headlines have focused on the fact that roughly only 10% of large cap funds outperformed the S&P 500 over five years. 

    However, whilst painful for all concerned, this is not particularly unusual. There have been four times in the past 50 years when US active managers have had a similarly rough time – in the mid 70s, late 80s, during the tech-driven market fall around 2000 and over the past five years. The current period of underperformance has probably been caused by a combination of cash drag in strong markets, an allocation to non-US holdings (with the US outperforming other regions) and large caps doing well (with a lot of active managers being underweight large cap stocks). Given this cyclicality, we believe now is precisely the worst time to give up on active US equities.

    Why you shouldn’t give up – specifically on high conviction, bottom-up, patient strategies

    ‘Going passive’ means giving up on the world’s most abundant market for long-term active growth companies. The US produces over half of the world’s fastest growing companies globally by market cap. 

    Importantly, long-term and highly active investment strategies work. These strategies are increasingly important as rapid technology-driven change is likely to create a clear divide between stock market winners and losers. There is academic evidence that patient, high-conviction investment strategies can beat the index. This is the style we employ.  

    The key to delivering outstanding long-term performance is to focus all efforts on finding and owning these exceptional companies. It seems obvious, but owning the outliers in the skewed distribution of market returns matters. It is this asymmetry of returns that we want to capture in the portfolio. Why do we think these companies are so important? Well, over the past 90 years half of the wealth created by listed US stocks, approximately $32 trillion, was delivered by just 86 out of 25,782 listed companies – that’s just 0.3%. The return distribution of all listed common stocks is positively skewed by these few outliers. This runs counter to mean-reversion theory and dedicated followers of the Capital Asset Pricing Model which assumes a normal distribution. The majority of stocks underperformed cash (T-Bills). 

  6. Long-term active managers outperform

    Outperformance relative to passive net of fees

    Source: Cremers and Pareek 2015, Patient Capital Outperformance.

    Past performance is not a guide to future returns.

     

    Yes, passive strategies capture all market returns, including the outliers. But we contend that this is a sub-optimal approach for long-term returns. The median return of stocks over the same period was negative; and you virtually guarantee below market returns after fees. Further academic evidence supports our contention – high active share, low turnover and bottom-up stock-picking are all good predictors for long-term outperformance.

    The graph above shows why this is so important. Over a 27 year period (a more relevant time period for most of us), stocks held by high active share and patient institutional US equity portfolios accumulated an outperformance of 80% over closet index funds, high-turnover funds and passive funds. Adding real numbers brings home the reality. A closet index fund1 or passive strategy that delivered a $10,000 pot, could have instead been an $18,000 pot. A $40,000 pot could have been $72,000 pot. And so on. These numbers matter for investors.

     

    1. Closet index funds are funds that claim to actively purchase investments, but wind up with a portfolio not much different from the benchmark.

  7. The portfolio reflects our optimism 

    We don’t have a particular view on the US economy or aggregate valuations; rather, we are excited because we think some of the best opportunities in the world are in the US market. These powerful growth franchises don’t have peers in other stock markets. As they grow they are attacking many established industries. They are making life increasingly difficult for the big companies that comprise the major stock market indices and, in turn, making passive investment riskier.

    Some of the major themes expressed in the portfolio illustrate this point.

    Big platforms 

    Amazon, Google and Facebook are some of the largest holdings and they have been strong contributors to performance. We apply a minimum return target of 2.5 times over five years for all stocks in the portfolio. But we think these particular businesses are different both in terms of the size of the opportunities they address, their competitive advantages and how they scale.

    A truly remarkable fact about Amazon, for example, is that it is taking over half of the incremental retail dollars that are flowing online. There has never been anything like this in the offline world. We see similar patterns of dominance in online advertising with Google and Facebook. 

    Healthcare 

    Healthcare has been an increasing area of focus for the team. There is huge unmet need in healthcare, and there is lots of room for improvement. As part of our research efforts, one of the team, Gary Robinson, is spending a month in San Francisco over the summer meeting with a range of companies and thought leaders. We’ve also appointed an experienced healthcare journalist to help guide us through some of the big-picture topics. 

    The tangible output of this is that around 19% of the portfolio is in innovative healthcare companies. There are names you’ll be familiar with, such as Illumina, but also more recent additions such as cancer biotech Celgene, the maker of the world’s smallest heart pump Abiomed, and cystic fibrosis company Vertex.

    Operations Inside an Amazon.com Inc. Fulfillment Center
    © Bloomberg/Getty Images.
  8. …we are excited because we think some of the best opportunities in
    the world are in the US market.
    Autopilot side repeater camera. © Tesla.
  9. Founder-run companies

    Founder-run businesses make up around 70% of the portfolio by weight. This compares to a weighting of around 12% in the S&P 500 that have founder CEOs. The characteristics that founders bring to companies are especially important given our return target and time horizon. Founder-run businesses are often managed with vision and ambition. They would rather invest than buy back shares. Having a founder still involved with a company is not a prerequisite for inclusion in the portfolio; ultimately, we’re looking for businesses that grow faster, for longer and at higher rates of return –  many businesses that aren’t founder-run achieve this; however, we’ve found that founder-run businesses have a much higher chance than average of doing it.

    Two recent additions to the portfolio, although from very different sectors, reveal our focus on finding companies with distinctive cultures, large growth opportunities and sustainable competitive advantages.

    Activision Blizzard is the world’s largest dedicated video game publisher. This founder-run company is benefiting from the shift to mobile gaming. With the recently established eSports and movies divisions, it will further leverage its existing intellectual property, giving its loyal fan base new media in which they can enjoy and consume more content.

    HEICO is a disruptive force in the commercial aerospace industry. It is the global leader in the design, manufacture and distribution of approved ‘generic’ aircraft parts. These generic parts are significantly cheaper than those sold by the original equipment manufacturers. The generic parts market is currently only around 1%–2% of the total aerospace parts market; therefore, this family-controlled business has a huge opportunity to grow.

    These purchases were in part funded by the sale of M&T Bank. While we believe that M&T is a well-run bank with a prudent lending culture, its modest growth prospects from here were not attractive enough for us.

     

    Image: © Getty Images Europe.

  10. Outlook

    Finally, one other piece of research, Active Share and Mutual Fund Performance (2013) by Antti Petajisto, found that factor bets are not a good predictor of US equity fund performance. Prognosticating on politics and macroeconomics can be interesting, but transposing these opinions into sector allocations is not a reliable way to make money in the long run. So, despite the thoughts we may have on the current state of US politics and GDP figures, our focus is resolutely on the portfolio and patiently seeking out companies that could help deliver exceptional returns over the long term. We look forward to the next 20 years of investing in US innovation.
  11. Important Information and Risk Factors

    This article contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.

    Any stock examples, or images, used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.

    As with all mutual funds, the value of an investment in the fund could decline, so you could lose money. The most significant risks of an investment in The US Equity Growth Fund are, Investment Style Risk, Growth Stock Risk, Long-Term Investment Strategy Risk, Geographic Focus Risk, Non-Diversification Risk, Conflicts of Interest Risk, Equity Securities Risk, Focused Investment Risk, Information Technology Risk, IPO Risk, Large Capitalization Securities Risk, Liquidity Risk, Market Disruption and Geopolitical Risk, Market Risk, New and Smaller-Sized Funds Risk, Service Provider Risk, Small-and Medium-Capitalization Securities Risk. For more information about these and other risks of an investment in the fund, see “Principal Investment Risks” and “Additional Investment Strategies” in the prospectus. The US Equity Growth Fund seeks capital appreciation. There can be no assurance, however, that the fund will achieve its investment objective.

    The fund is distributed by Baillie Gifford Funds Services LLC. Baillie Gifford Funds Services LLC is registered as a broker-dealer with the SEC, a member of FINRA and is an affiliate of Baillie Gifford Overseas Limited.

     

    The Baillie Gifford US Equity Growth Fund (Share Class K)
    as at 30 June 2019

    Gross Expense Ratio 7.75%
    Net Expense Ratio 0.65%


    Source: Baillie Gifford & Co.

     

    Standardised Past Performance to 30 June 2019 (%)

      3 Months* YTD* 1 Year Since Inception

    The Baillie Gifford US Equity Growth Fund (Share Class K)

    7.00

    26.60

    8.48

    27.02

    S&P 500 Index

    4.30

    18.54

    10.42

    14.17


    Source: Bank of New York Mellon, S&P. Net of fees, US dollars. *Not annualized. Returns are based on the K share class from April 28, 2017. Prior to that date returns are calculated based on the oldest share class of the Fund adjusted to reflect the K share class fees where these fees are higher. Fund inception: December 05, 2016. The Fund is more concentrated than the S&P 500 Index.

     

    The performance data quoted represents past performance and is no guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month-end performance please visit our website at www.bailliegifford.com/usmutualfund/usequitygrowthfund

    The Baillie Gifford fund's performance shown assumes the reinvestment of dividend and capital gain distributions and is net of management fees and expenses. Returns for periods less than one year are not annualized. From time to time, certain fees and/or expenses have been voluntarily or contractually waived or reimbursed, which has resulted in higher returns.

    Without these waivers or reimbursements, the returns would have been lower. Voluntary waivers or reimbursements may be applied or discontinued at any time without notice. Only the Board of Trustees may modify or terminate contractual fee waivers or expense reimbursements. Fees and expenses apply to a continued investment in the funds. All fees are described in each fundís current prospectus.

    Expense Ratios: All mutual funds have expense ratios which represent what shareholders pay for operating expenses and management fees. Expense ratios are expressed as an annualized percentage of a fund's average net assets paid out in expenses. Expense ratio information is as of the Fund's current prospectus, as revised and supplemented from time to time. The net expense ratios for this fund are contractually capped (excluding taxes, sub-accounting expenses and extraordinary expenses), through 30 April 2020.

    The S&P 500 Index is a free float-adjusted market capitalization weighted index that is designed to measure large capitalization equity market performance in the United States. This unmanaged index does not reflect fees and expenses and is not available for direct investment.

     

    US Equity Growth Fund Top Ten Holdings 
    As at 30 June 2019

    Holdings Fund %
    1 Amazon.com     11.04
    2 MarketAxess 5.80
    3 Shopify 5.31
    4 Netflix 5.21
    5 Wayfair 4.87
    6 Illumina 4.75
    7 Facebook 3.93
    8 MasterCard 3.83
    9 Alphabet 3.74
    10 The Trade Desk 3.60

     

    It should not be assumed that recommendations/transactions made in the future will be profitable or will equal performance of the securities mentioned. A full list of holdings is available on request. The composition of the Fund's holdings is subject to change. Percentages are based on securities at market value.


    S&P 500 Legal Disclaimer

    The S&P 500 and S&P Global Small Cap (“Index”) is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

     

    Asymmetrical Returns – Top and Bottom Five Stock Returns

    Source: StatPro. Returns for the US Equity Growth Fund from 30 June 2018 to 30 June 2019 in US dollars.

    It should not be assumed that recommendations/transactions made in the future will be profitable or will equal performance of the securities mentioned. A full list of holdings is available on request. The composition of the Fund’s holdings is subject to change.

    Not all stocks were held for the full period above.

     

    Re: 42053 USM WE 0046