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6 tips for choosing funds

This article is about investing in general, not about Orbis Access in particular.

Choosing a fund

Which one’s right for you?

People often spend hours investigating which mobile phone to buy next, but may spend almost no time looking into the funds they are about to entrust a chunk of their life savings to. Arguably, that’s a bit bonkers.

With around 2,500 investment funds available in the UK though, it can be daunting deciding which ones are right for you. 

To get the list down to a manageable size, conventional wisdom is first to think about your objectives, the level of risk you’re comfortable with and then your overall investment strategy. Once you have an idea about these, it’s much easier to seek out investments that suit.

If you do decide to invest indirectly via funds, one important question is whether to go for a ‘passive’ fund that simply tracks the movement of a market index (such as the FTSE 100), or one that is ‘actively’ managed and attempts to outperform the market. There are several factors to consider in the active vs. passive fund debate.

Here are three dos and don’ts to consider when selecting active funds. This is not an exhaustive list, but should set you off in the right direction…

Do research or get help

As well as reading up on information published by the funds themselves, seek out authoritative recommendations and commentaries online and in the press. Agencies, such as Morningstar and Citywire, provide information and fund ratings which can also help. Concentrate on what the fund does and how it’s run rather than recent performance.

Some managers have become ‘stars’ of the finance world by running funds that consistently outperform the competition. Unfortunately, there is no guarantee that their fund(s) will continue to outperform, either through skill or luck. Other funds, by contrast, prefer to focus on a team-based approach and avoid reliance on individual stock-pickers.

Alternatively, you can delegate the whole business of selecting funds.  Independent Financial Advisors (IFAs) provide tailor-made financial planning. While this often includes fund selections, their services tend to be broader than the narrower question of choosing suitable funds. So-called ‘robo-advisors’, meanwhile, provide more of an off-the-peg solution.

Do remember the risks

Stocks & Shares go down in value as well as up, so your investment returns fluctuate – sometimes quite dramatically – and you may get out less than you put in. This means your capital is at risk in a way it wouldn’t be if you stuck to saving cash in the bank. There is a relationship between risk and rewards, so a fund generating high returns may be doing so because it’s making riskier investments.

Do look closely at costs

One reason the majority of active funds fail to beat their benchmarks is because they are weighed down by management fees. Seasoned investors demand value for money and keep a close eye on fees. A fee of 1% may not sound like a lot, but it could consume a quarter of your returns each year, which gets compounded.

Another criticisms levelled against some active funds is that they buy and sell shares too often, with this ‘churn’ incurring trading costs that also drag down performance. To make matters worse, funds rarely disclose trading costs. They are not included in the Ongoing Charge or Total Expense Ratio (TER) figures you see quoted, for example.

To put fees in perspective: The average annualised real return of a portfolio comprising 60% UK shares and 40% bonds was 3.74% (between 1900 and 2013).* That figure does not account for fees. So, subtracting 1% in fees leaves just 2.74% for the investor. And with fees plus expenses running at 2%, on average, investors would’ve been left with less than half their gains annually.

Don’t chase recent performance

A common error made by investors is to compare performance of active funds and conclude that the ones with the best recent results are likely to the best bet in future. Unfortunately, chasing fund performance is rather like chasing the pot of gold at the end of a rainbow. The reality is that recent performance is not a reliable indicator of future success.

A study by Standard & Poor’s makes the point that few funds can consistently stay at the top. Only 3.8% of 687 US funds that were in the top quarter performance-wise in March 2012, managed to keep it that way all the way through to March 2014 (source: S&P).

That said, it’s unrealistic to suppose a fund will be consistently ranked among the best performers without suffering any bouts of underperformance along the way. After all, even the best sporting teams lose the occasional game on the way to winning the championship.  There are funds that have out-performed the market over the long term, in spite of performance hiccups along the way. One way of assessing a funds’ performance is to check its long-term performance (5-10 years) against its benchmark.

Don’t fall for closet indexers

A significant proportion of fund managers run scared of deviating too far from their benchmarks. The upshot is that their funds can behave rather like the benchmark.  Such closet index funds beg the question whether it might make sense to opt for a passive fund with lower fees instead.

On a brighter note, some active equity funds do dare to be different. They are willing to accept that their performance may diverge significantly from their benchmark - for better or worse - especially over the short term.

One way of measuring this is Active Share. This is the percentage of a fund’s portfolio that differs from its benchmark. An active share of 50% therefore means that half the shares held by the fund differ from the benchmark. Unfortunately, many funds don’t publish this figure. To avoid closet indexers, you would be looking for an Active Share of at least 60%, ideally higher.

Don’t be too trendy

Fund management, like the rest of the world, is prone to fashion. Is farmland in Africa the latest thing? What about financial services in China? Maybe Technology stocks will again be all the rage, as they were in early 2000?

History is littered with examples of fashionable stocks that didn’t live up to expectations (along with a few that did). Standard advice is to maintain a diversified portfolio of investments and avoid concentrating too much on a single business sector, however fashionable it may be. As with chasing performance, this year’s hot trend could be next year’s has-been.

*Source: Credit Suisse Global Investment Returns Yearbook 2014

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