by Mark Dampier
Risk
Some funds are riskier than others. Mainly this is because the area in which they are investing happens to be inherently riskier than those where other types of fund are investing. So, for example, funds that invest in shares are usually riskier than fixed-interest funds, and funds that invest in countries like Russia or Brazil are riskier than those which invest in the UK or United States. This tells you nothing about the skills of a fund manager. What it tends to mean is that when share prices generally are rising, a higher-risk equity fund will do better than the average, but less well than the average when the market is falling. As an investor you want to make sure that you understand and are comfortable with the risk that a fund is taking.
Investment style
Fund managers vary quite a lot in the processes they use to identify investments to include in their funds. Some are value investors, looking for shares or bonds that appear cheap against some absolute or relative metric. Others are more interested in finding shares with above-average growth potential. Some funds concentrate on larger companies, others on smaller companies. These styles will move in and out of favour, flattering the results of funds that follow the in favour styles. What you are looking to find are fund managers who can do consistently better than others who follow the same approach. There is not much point comparing funds with different styles.
Experience
Experience is one of the most important criteria. Investment is one of the few areas of professional life where you can clearly say that the best get better with age. The mistake that many people make is to look at how a fund is doing over too short a time period. Because markets and investment styles move in cycles that last several years, my view is that it is almost possible to judge how good an individual fund manager is until you have seen how he or she has fared over at least two of these cycles. In practice that means that you need to look at ten years of performance (and ideally even more).
That is what I do, taking into account the fact that the manager may have changed employers over that time. It is his or her track record that matters, not the fund when it was under somebody else’s control. That is also why most of the funds that I own are run by managers who have been around quite a long time.
Fees and other charges
I have already mentioned how important the cost of your investments can be in determining the final value of your investments. Every 0.1% extra in cost you pay each year for a fund potentially reduces your annual return by the same amount – and those costs will compound remorselessly over time. All funds charge you what is called an annual management charge (or AMC), which is calculated as a percentage of the current value of your holding. A typical annual management charge is around 0.75%, meaning that for every £1,000 you have invested in a fund, the fund manager will deduct £75 a year in charges. As your fund holding grows in value, so too will the amount you pay, on a pro rata basis – so if the fund doubles in value, so will the amount you pay. In addition to the annual management charge, funds can also bill you for a number of additional costs, such as custody, although the extent to which fund companies do this varies enormously. The AMC and the additional costs together go to make up the ongoing charges figure, or OCF, of a fund. Some funds also charge what is called a performance fee – an additional amount that is only deducted if the fund beats a pre-determined performance target.
Since new rules came into force in 2013, fund companies have been free to set their charges at whatever they think the market will bear. In practice there is now a huge divergence in what funds cost. Some large players in the market, including my firm, have been able to negotiate lower fees for their clients than other investors have to pay. All this means that it is doubly important to find out what the total cost of owning a fund is likely to be before you buy it. However, it does not follow that the cheapest funds are invariably the best. In the case of passive funds, which are essentially commodities, it is broadly true, but for actively managed funds, you tend to pay for what you get – the question is whether a fund manager is really good enough to command a premium rating. I offer more thoughts on this hotly debated issue in the next chapter.
Points to remember
There are thousands of funds from which to choose.
The industry breaks them down into several categories.
Passively managed funds aim to match, not beat, a relevant market index.
Actively managed funds aim to do better than that, but most fail to do so.
Income funds have explicit yield targets; others prioritise capital gains.
It is best to focus on total return – income and capital gains combined.
It is more important to look for the best funds in each sector than to pick the sectors first.
The best fund managers tend to have been around for quite some time.
The all-in costs of a fund are important, but not the whole story.
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8 The main types of bonds are those issued by governments (known in the UK as gilts) and those issued by companies (corporate bonds). Index-linked bonds are a special type of bond whose income and capital values are linked to the price of inflation. Corporate bonds are classified as either investment-grade, if their credit standing is good, or high-yield (‘junk’) if riskier.
9 The FTSE 100 index tracks the performance of 100 of the largest companies on the stock market. The FTSE All-Share Index tracks more than 600 companies, including therefore many smaller companies.
10 Some funds pay dividends quarterly.
Chapter 5. How to Pick the Best Funds
Choosing the right fund for your purposes is probably the most difficult decision you have to make as an investor. It can turn out to be more important than your broad asset allocation, crucial though that also is. I have already touched on some of the important factors to consider in the last chapter. Here are some more detailed thoughts on the various facets of distinguishing what makes a good fund from a bad one.
When reading it, you should bear in mind my earlier observation that 90% of funds on offer are probably not worth the money you are being asked to own them – but the ones that are very good are, and they are obviously the ones that you want to have.
Funds and fund companies
I believe that many people choose their investments the wrong way round. They go for a fund company first and only then decide on which fund or funds to buy. In my experience you will do better to look for a good fund first, the one that gives you the best exposure to its chosen country, sector or theme. Which fund management company runs the fund, while not at all unimportant, should be the secondary factor. The size or reputation of the company running the fund is not as important as many investors seem to believe.
It is true that some of the larger companies offering funds have higher profiles, but that does not mean that they are necessarily superior. It may just be that they spend more money on advertising and marketing – an expense which, incidentally, is ultimately paid for by you as the fund investor. Most of the biggest fund companies offer a wide range of funds, knowing that some will do better than others, but there is no guarantee that all of them will be of the same standard, as so much depends on the skills and experience of the individual fund manager. I have already mentioned the generally disappointing performance of funds offered by the big banks. Personally I have rarely owned more than two funds from the same stable.
The good news is that there is a lot of competition within the fund management industry. This means that new names are appearing all the time. Starting a fund management company can be a very lucrative business, even if it starts small. Small ‘boutique’ fund management companies often start with just two or three funds, typically in niche areas. Quite often they will be started by experienced fund managers who have become frustrated working within a big company environment, where they can find themselves spending more time managing o
ther people than doing what they do best, which is making investment decisions. By setting up on their own they become owner-managers with a significant ownership stake in their business. This not only gives them an incentive to perform, but also means they are less likely to leave or be poached by other companies, something which is a constant aggravation for both advisors and private investors alike.
Boutique firms of this kind, where managers take control of their own business, are often well worth following. While the company itself may not have a track record, the fund manager running the funds usually does. Artemis and Lindsell Train, to give just two examples, both started out with little or no money to manage, but now run many billions of pounds successfully for investors. The most prominent recent example of a fund manager setting up on his own is Neil Woodford. He left the giant Invesco Perpetual in 2014 after 25 years to start his own business, Woodford Investment Management. Sanditon and Crux are two other recent examples where experienced fund managers have left to set up on their own. There is no reason why investors should not look to have both large and small groups within a portfolio.
Remember too that in some cases the early years of a new fund, if it is run by an experienced professional, are the best time to be invested. If you wait for a three-year track record to develop at the fund manager’s new home, you may miss some of the best opportunities. Why is that? Because when funds are still getting off the ground, the fund managers have more flexibility to back their highest-conviction ideas. A common problem with larger firm funds is that the fund reaches such a size that it becomes more difficult for the manager to find the opportunities he could do when the fund was much smaller.
Investment style
The investment style of a fund can have a huge bearing on the performance of your portfolio, something which is not always well-understood by many private investors (or for that matter many financial advisors). One of the most important style differences between funds is that between a ‘growth’ and a ‘value’ approach. A growth manager is primarily interested in companies with strong earnings or profits growth. This typically leads them to have a high exposure to companies which pay little by way of dividends. A value manager, on the other hand, looks at companies whose valuation appears cheap when compared with its profits, cash flow, dividends or assets. This in turn often means a predominant exposure to shares with good dividends.
Value investing has the better long-term record. The trouble is that both styles can go in and out of fashion, sometimes for years at a time. Some of the time growth beats value, and some of the time – more often, in fact – it is the other way round. Figure 5.1 shows how the two different styles have swung in and out of favour since 1990. If you buy a fund with a value approach, represented here by the high-yield index, you will do better when that style is in favour, as it has been for most of the time recently. Although value investing produces the best long-term results, you cannot rely on it doing so every year. This kind of change in performance has little to do with the skills of the fund manager. It is purely the result of a style shift.
Figure 5.1. How investment styles come in and out of fashion.
It is true that some funds are blended, leaving their managers to have both styles represented in their portfolios. Their objective is then to try and vary the weight of each style, according to their reading of which style is likely to be next in favour. The difficulty is that these style shifts are notoriously difficult to time correctly. The results of getting them wrong can be painful. As a fund investor yourself, you can neutralise style effects by having both types of fund in your portfolio, but to do that requires an additional level of research. Most fund companies and platforms describe the investment approach of specific funds, while the Morningstar website classifies funds on a nine-box style matrix, designed to show the extent to which a fund veers towards large or small-cap shares and whether it is biased towards growth or value. This can be a useful starting point for further analysis.
Small caps for the longer term
The size of the companies whose shares an equity fund manager is buying needs considering because of the broad cycles that favour one or the other at any one time. At certain times so-called blue chips, the largest companies with household names, will perform better than small companies, and vice versa at other times. Between 1996 and 1998, for example, blue chips had a very strong run all over the world. Portfolios which were over exposed to mid-sized and smaller companies, their lesser brethren, were left lagging far behind. Then in 1999, when the valuation difference had become extreme, small companies started one of their strongest runs for years.
Since 2000, smaller companies have generally produced much stronger performance, and this has benefitted a number of specialist small-cap fund managers, such as Giles Hargreave, Harry Nimmo and Dan Nickols. Their funds have naturally attracted strong inflows on the back of their stronger performance. But that cannot continue indefinitely. Small company specialist funds, being more volatile, fell more sharply than large-cap funds during the bear market of 2007–09. And despite recovering strongly after that, since the start of 2014 smaller company funds have again mostly lagged behind.
Predicting whether large or smaller company funds will do better is difficult, so it makes sense to keep a balance between the two. Over the very long run, smaller company funds have generally outperformed larger ones, in part because they are higher-risk – when markets fall, small-cap funds fall faster and further. You might think it makes sense to have, say, 50% in larger companies and 50% in smaller company funds. However, it is worth remembering that when commentators talk about ‘the market’ in the UK or US, they typically mean the blue-chip indices like the Dow Jones in the United States and the FTSE 100 in the UK. If you look at the market value of the companies in those indices, they dwarf everything else.
Measured by market capitalisation, the 100 companies that make up the FTSE 100 index represent as much as 85% of the FTSE All-Share Index. The ten largest companies account for roughly 40% of the value of the index. If your portfolio only has a 50% weighting in FTSE 100 stocks, you are effectively making a big bet that smaller companies will outperform larger ones. That will work quite well a lot of the time, but in the long run you will not do as well as you expect. In practice most actively managed investment funds have a bias towards stocks outside the FTSE 100 index, so it is easy to find yourselves inadvertently making a smaller company bet without realising it. Yet again, therefore, it pays to look carefully at how and where your fund managers are investing your money.
Making sense of performance figures
This leads us on to the use of past-performance data. It is obviously right that funds should disclose as much information as possible about their past performance. For a number of years, before regulators stepped in to insist on standardised reporting of results, fund managers had much greater flexibility to present their figures in the most favourable light. Now that every company has to present its figures the same way, the risk that you will be given misleading information has reduced, although the amount of information you get may also reduce too. While that is a positive step forward, it does not mean that you are out of the woods. Interpreting past performance is a notoriously complex and difficult task.
When I talk to investors, I always stress that past performance should be only one of the tools to look at when you are considering a fund. The regulators insist that every fund has to remind investors that past performance is not a guide to future performance, and that is absolutely right. First-time investors often assume that if a fund has done well in the past, it will continue to do so. But that is clearly not the case. As we have seen, the standout feature of investment markets is that they move in cycles. Bull markets are followed by bear markets – and within each of those phases, at different times not only will smaller companies do better or worse than large ones, but some sectors will do better or worse than others and the same goes for individual companies and co
untries.
There are so many moving parts that determine which investments do well and which do not, in other words, that it makes interpreting fund performance highly complex. A fund that invests in smaller companies will obviously do better when smaller companies are in favour and less well when they are not. Paradoxically, the fact that it has done better than a large company fund over the past five years actually makes it less likely that it will do better in the next five years, because these style shifts tend to even out over time.
And all this is before we even consider whether the manager of a fund has added any value through his or her efforts. Suppose you are looking at two equity income funds that have exactly the same objective: does the fact that one has done better than the other over, say, the past three years tell you anything about how good the fund manager is – and just as importantly, whether or not the fund will also do better over the next three years? What if one fund has done better over one year and the other over three years? You have to dig pretty deep to come to a conclusion on which fund is worth buying.
In my experience past performance is certainly not a guarantee of future returns, but it can be a useful indicator as to when to buy or sell a fund. To take an extreme example, if the past performance figures show a fund is up by 100% in the last year, that might well be telling you to avoid buying the fund now, because in the short term what is in the fund is more than likely to be fully valued – otherwise it could not have done so well. Conversely a fund with poor performance over the previous year might just be telling you the opposite story.