Effective Investing

by Mark Dampier

  Schroder Absolute UK Dynamic

  The Schroder Absolute UK Dynamic fund, as its name implies, is a so-called absolute return fund, one which rather like Artemis Strategic Assets aims to do well in all kinds of markets. For a number of years I used it to provide more ballast for my portfolio. It balanced some of the more aggressive equity-only funds I hold, and offered some protection against losing too much if and when the markets turned down. The fund was run by Paul Marriage, an experienced small-cap specialist, alongside another more traditional small company fund. It was rebranded as a Schroder fund after his former employer, Cazenove, was bought by Schroders a couple of years ago.

  The fund focuses primarily on medium-sized and smaller companies, and is somewhat more aggressive than other absolute return funds, meaning that Paul is prepared to accept some modest short-term losses within the overall mandate of targeting a modest positive return in nearly all periods. Typically he will hold around 60% of the portfolio in companies that he particularly likes and the remainder will be short positions in companies that he thinks will fare relatively poorly, a strategy known in the industry as running a long-short portfolio).

  The track record has been pretty good, unlike most funds in the absolute return sector, which have generally been very disappointing since they first appeared on the scene. (One fundamental reason may be that it is simply very difficult to do what they aim to do.) There have been periods when the fund has been closed to new investors. However, as with the Old Mutual fund, given my greater interest in finding new sources of income, it no longer features in my portfolio.

  Points to remember

  Think of your SIPP, ISA and other holdings as one big portfolio.

  Your pension fund is really just another investment fund.

  You are likely to need more income as you near retirement. Income units and equity income are useful, flexible tools for that purpose.

  Put a maximum limit on how much you hold in any one fund.

  Avoid making too many decisions – try to keep it as simple as you can.

  If you find a good fund manager, it is a good idea to back him or her with a significant chunk of your money.

  Make sure you understand what a fund’s philosophy is and whether it is in line with your objectives. That way you won’t be surprised at how it behaves.

  * * *

  15 Jason Pidcock, the manager of this fund, later left to join another fund management firm, prompting me to put this fund holding under review.

  16 Please note that I describe my thoughts on venture capital trusts and individual shares in more detail in chapter 8. They are not covered in this section, although they make up a good chunk of my overall investment portfolio.

  17 Richard Woolnough, who manages fixed-income funds for M&G, now has £35 billion of client money in his funds.

  18 This has not been true of the last few years, however, when the UK market has tended to lag the world index. One reason is that the world index is dominated by the US stock market, which has performed much more strongly since the financial crisis than most other stock markets.

  Chapter 8. Other Ways to Invest

  Passive investing

  There is no doubt that so-called passive investments, in the form of index funds and exchange-traded funds (known as ETFs), have become a lot more popular in recent years. We can see that on the daily traffic on the Hargreaves Lansdown website, where we now publish regular research on both index funds and ETFs. (The key difference between the two is that the former can only be bought and sold once a day through the issuing company, while the latter can be bought and sold throughout the trading day in the stock market, just like shares.) The number of markets and sectors that are now covered by passive funds has grown enormously in the last 20 years, which if nothing else is good for choice.

  While I don’t own any myself, I would never say that passive funds are to be avoided. A broad market index fund can be a good starting point for a first-time investor looking to gain exposure to the UK or world stock markets. Until or unless you have confidence in your ability to pick the best actively managed funds, buying a plain vanilla tracker fund is the simplest and most efficient way to make a start as an investor. If you do buy an index, or tracker, fund, your first objective is to find a suitable index, such as the FTSE 100 or All-Share index. Next you need to make sure that the fund actually does what it say, namely track its benchmark index as closely as possible. Surprisingly, not all do that job that well. It can be an effort to find out what a fund’s so-called ‘tracking error’ is, but it is an important piece of information. (Tracking error is measured as a percentage, and you are looking for a fund with a tracking error of less than 0.25%.) Index funds generally work best when tracking an index in the world’s biggest, most liquid, stock markets.19

  Assuming that they do the tracking part well, the objective then is to pick the funds that have the lowest charges, just as you would with any other commodity, which is what tracker funds essentially are. Costs are usually the biggest factor in determining tracker fund performance. Some of the core UK tracker funds we suggest, where HL is able to use its buying power to negotiate a particularly attractive price, have ongoing charges of less than one tenth of one per cent a year. For funds that track the main indices in big overseas markets, such as the S&P 500 index in the United States, or the Nikkei or Topix indices in Japan, the charges are typically somewhat higher, but still reasonably competitive.

  It is worth making the point that the more exotic the index being tracked, the higher the charges become and the more of a drag, invariably, those charges will impose on performance. The higher the charges, the more certain it is that those funds will fail to meet their own declared objective of matching the performance of the stock market they are seeking to replicate. Some of the earliest tracker funds that were launched in the UK back in the 1990s had shockingly high annual charges of 1% or more. If you do the maths, over a period of say ten years a fund with that level of charges is guaranteed to underperform its benchmark by a cumulative 15%, even if it tracks the index perfectly! That is money that comes straight out of your pocket and is a long way from being the market-matching return that you might have thought you were being promised.

  One technique that tracker funds use to offset the adverse impact of their charges is a practice known as stock lending, where a fund lends its holdings to a third party in exchange for a modest fee. That brings in some useful revenue and helps to reduce the tracking error, but it also creates some additional risk. I would only recommend a fund that lends stock if the investors see the benefit in the form of lower fees and the risks are clearly disclosed and carefully managed. You need to make sure that you know whether your tracker fund is stock lending or not.

  The argument for tracker funds is that they can be a reliable way to achieve better returns than the average fund in their sector. If the majority of actively managed funds underperform their benchmark, a tracker fund that actually does its job of replicating the performance of its index must, as a matter of definition, finish in the top half of the performance tables. If you are worried about the risks of losing money, that may be an important consideration. But if you think of fund performance being like football, even the most effective trackers will always be Championship rather than Premiership teams – decent, solid performers, but always in the second tier, not the first.

  The question then is: why settle for second best if you can have the best? If you believe, as I do, that in-depth research and years of experience can help you identify the best funds in their sector, the case for picking actively managed funds is clear. Of course, actively managed funds do better in some markets than others – the US market has proved a particularly hard market for active managers to crack – but the only fundamental advantage of a tracker fund for most investors is that it eliminates specific fund manager risk. They can be a perfectly re
asonable choice for investors who either prefer not to do their own research or don’t feel qualified to assess fund manager risk. As they should always have cheaper running costs, you do at least have the certainty of knowing that you are getting what you pay for – something that by definition is never the case with actively managed funds.

  It is worth pointing out that not all ETFs are quite as simple or useful as the conventional index-tracking funds of the kind that I have been describing. There are actively managed ETFs as well as passive ones. Some of the more esoteric ones may, for example, be offering you the chance to make a leveraged bet on commodities. They can be extremely dangerous instruments that can easily lose you most of your money if the markets they are following go the wrong way. So it is important when looking at the range of ETFs to make sure that they really are what you think they are. As a general rule ETFs are in practice mostly used by traders who are speculating rather than investing in the traditional sense of the word. You should leave that kind of thing to the professionals.

  Investment trusts

  I have not said a lot so far about investment trusts, although I do own one or two myself (as you will have seen in the chapter on my personal portfolio) and they are in some respects an ideal investment vehicle for the DIY investor. Many of the principles of investing I have discussed in relation to unit trusts and OEICs apply equally to investment trusts, but it is undeniable that they are slightly more complicated and harder to explain, which can be a deterrent. While I have tried to spare the reader too many definitions and explanations, as they can easily be found on the internet, you will have to excuse me for going into slightly more detail in this section.

  How investment trusts differ from unit trusts is that they are (a) closed-ended and (b) trade on the stock exchange. This means that to start life they need to raise money through a public offering of shares (an IPO, in technical jargon) and this gives them a fixed amount of starting capital. Unlike unit trusts, which create or cancel units at will, they can’t grow or reduce their assets anything like as easily as a unit trust can.20 The net asset value of an investment trust generally rises and falls in line with the market and the expertise of the fund manager. Consequently, whereas the price of a unit in an open-ended fund should nearly always track its net asset value very closely, this is not so with investment trusts, whose share price is influenced by supply and demand.

  If the trust is in fashion, or performance is stonkingly good, the shares may stand at a premium to net asset value. If you buy shares in the trust in these circumstances, you will be paying more than its current assets are worth. If on the other hand demand is poor or non-existent, and performance has been indifferent or worse, the trust’s shares may well slip to a discount. The share price will then stand below the net asset value of the trust; now when you buy the shares, you will be paying less than the underlying value of its assets.

  Got that? I can assure you that it isn’t as complicated as it sounds. In simple terms, buying shares in an investment trust when they are at a discount is broadly a good idea – akin to something being in the January sales. Buying at a premium, however, certainly if it is more than say 3% to 5%, is usually a poor idea in the long run. There are some nuances behind this simple formula however! It depends a lot on why the discount has come about. If it is because the fund manager is no good and the trust’s performance reflects that, the case for buying is weak, even if the price is a bargain basement one. But if it is because the whole sector is unfashionable, unwanted and unloved, it can often be an indication of genuine value and you should investigate it as a potential buying opportunity. Even in the first case, it may be worth keeping an eye on the trust as the board of directors always have the power to change the fund manager for someone better. If this happens, you will tend to see the discount start to narrow, though rarely immediately, which may still give you time to get on board.

  When a trust is trading at a very large premium, it may be because the fund manager is exceptionally good, or more often it is an indication that the sector the trust invests in has become highly fashionable and therefore at risk of a sudden or dramatic change in sentiment. When a trust is trading at a premium of over 10%, it strongly suggests to me that you should not be buying it. It really has to go some in order to justify that kind of fancy rating. Even top-quality fund managers can see shares in their trust go from a premium to a discount. In those cases, however, they can often go back to a premium again, so keeping a watching brief on the share price and discount can be worthwhile, since from time to time it can throw up attractive opportunities.

  One of the best examples of that phenomenon over the last five years has to be the case of Fidelity China Special Situations, which nicely illustrates a number of issues I have already mentioned about the difference between good and bad funds. In this case the story includes one of the UK’s best fund managers, a sector that has drifted dramatically in and out of favour, and the impact of huge media exposure. The trust was born when Anthony Bolton, who had successfully run unit and investment trusts for Fidelity for more than 25 years, decided after a brief retirement that he wanted to move to Hong Kong in order to run a China fund for his old firm. Given his track record and high profile in the industry, coupled with the popularity of China as an investment theme, the launch of his new investment trust attracted a record amount of money, more than £500 million.

  Initially the fund performed well, and before long was trading at a premium of more than 15% to net asset value – a classic example of a warning bell sounding. What happened next was that the Chinese stock market started to perform less well, and a couple of Mr Bolton’s core stock selections turned out badly (one of his companies being accused of fraudulent accounting practices). Given his high profile, these problems inevitably hit the headlines in a big way. The fund slipped from a premium to a discount and, worse still, the share price fell as far as 70p, well below the issue price of 100p. The media was full of stories that Mr Bolton was unable to transfer his skills from the UK to China. Some gave the impression that he was over the hill and had lost his way. Many private investors expressed their disappointment by selling their holdings at between 70p and 90p a share.

  By the time Mr Bolton retired from running the fund in 2013, the media was still largely hostile, some going so far as to imply that his time at the helm had been a failure. Although performance had already improved, the shares at that point were still trading on a discount of 14% to net asset value. Yet as the following chart shows, the reality was that he had beaten the fund’s Chinese benchmark while he was in charge, which hardly justifies being called a failure. More to the point, he had already laid the seeds of a high-return stock portfolio. Since then the portfolio has blossomed under Dale Nicholls, its new manager. The Chinese stock market then recovered strongly, with the result that five years after launch shares in the fund stood at around 170p, more than double its price at the earlier low point.

  Figure 6.9: A matter of interpretation – the track record of the Fidelity China Special Situations fund.

  Those who sold out after the initial disappointing performance missed out on a chance to make a 70% gain. This neatly illustrates the fact that you shouldn’t believe everything you read in the media. A little time spent in research would have suggested that the move to a big discount was actually a classic buying opportunity, not a sell signal. Given that any equity investment should be seen as a long-term project, it was a mistake for investors to sell after just two years of experience, however disappointing the ride had been. The other point is that the Fidelity China Special Situations story illustrates how investing in investment trusts can be both more hazardous and more rewarding than investing in an equivalent unit trust, precisely because of the discount/premium cycle. It takes more work and more courage to invest this way – whether that is for you is a matter only you can decide.

  Another important difference between investment trusts and unit trusts is that inve
stment trusts can ‘gear’ their returns in a way that unit trusts cannot. What this means is that, if the board of directors agree, the trust can borrow money in order to boost the amount of capital that they have to invest. If the fund manager can make a greater return with this extra capital than it costs to borrow the money, the trust and its shareholders will be better off. (To continue the driving analogy, they have moved up a gear or two.) The scope for gearing is another factor that makes analysing investment trusts more complicated as the decision to gear or not can make a significant difference to investment performance. It also adds to the risk of share price volatility.

  Each trust makes its own decision, adding to the diversity of returns. Some investment trusts never gear, believing that their portfolio is already risky enough. Gearing can work both ways. When interest rates were much higher than they are today, many trusts mistakenly geared up by borrowing at a fixed rate, in some cases locking into permanently high borrowing costs. With the march of time this problem has gradually unwound. In a world of very low interest rates, as we have today, gearing does appear to make more sense. The effect of gearing means that investment trusts in general outperform their unit trust equivalents when prices are rising in a bull market, but are certain to suffer disproportionately the next time the stock market takes a tumble. Care therefore needs to be taken when comparing unit trusts and investment trusts. In the main, the last few years have been good to investment trusts, as they have had the double benefit of narrowing discounts and gearing. It will not always be so.