Choosing a collective investment

Tuesday, 3rd March 2015 16:09 - by David Harbage

This article should be read in conjunction with the educational blog entitled ‘Equity Vehicles’ dated 25 June 2012. The prime considerations when selecting a collective, otherwise known as a pooled, investment must include:

1. Ensure that the chosen fund incorporates the appropriate type of asset to meet your needs and that you are comfortable with the inherent risk of such investment. For example, a domestic equity vehicle might be favoured by a long term investor seeking a reasonably attractive level of income and in anticipation of growth in such income via higher dividend pay-outs from the underlying constituent company stocks. This asset type offers the prospect of capital appreciation, in recognition of the rising income distributions, but history also shows that the capital value of this kind of investment can be both volatile and fall (especially over shorter periods of time). Owning a collective managed by a star fund manager should not blind the investor to the nature and likely performance of the fund’s particular asset type. In similar vein, many funds are described as ‘Managed’, ‘Balanced’ or Growth and prospective investors should carry out due diligence to establish how the underlying fund is invested.
2. Having decided upon the asset class or classes which the investor believes are suitable to achieve their financial objectives in their current circumstances, consideration should be given to the available universe of collective funds. The educational Blog ‘Equity Vehicles’ discusses the merits and shortcomings of open and closed-ended funds, as well as those that seek to track or outperform a benchmark index. Issues covered include costs (it is not possible to invest in stock market assets ‘free of charge’), frequency and method of valuing or pricing the underlying assets (considering the impact of investors’ buying or selling the fund), which will help investors form a view on the type of collective they would prefer. 
3. If an actively managed fund is chosen – in the belief that the fund manager can outperform his or her benchmark (likely to be a stock market metric: for example the FTSE100 index) – the prospective investor should then carefully consider how the fund manager is planning to achieve such a goal. This strategy will be detailed by each fund and studying this, alongside perusal of the underlying portfolio of constituents, can provide an indication of the risk-reward profile of the fund. As an example, growth might be the prime or sole objective – as opposed to income – of a unit or investment trust, but fund factsheets or company reports on the portfolio might evidence very different strategies employed. For instance Old Mutual UK Alpha fund is managed by Richard Buxton (best known at Schroder) – who is growth-oriented, often more bullish of economic growth & markets than the consensus, is typically contrarian and has taken big positions in economically sensitive banks & retailers – while CF Woodford Equity Income fund is managed by Neil Woodford (who established his reputation at Invesco Perpetual); he has a particularly bearish outlook on the economy, seeks to minimise any permanent loss in capital and favours defensive business activities like pharmaceuticals, tobacco & telecommunications. Both invest principally in domestic equities and have typically been successful - but by possessing different views and adopting different investment styles and policies.
4. Beyond the rhetoric of fund commentaries, the perceived magnitude of risks being taken by different fund managers can be assessed and measured in other ways – notably against the fund’s objective or benchmark. The number of portfolio constituents and size of those positions (which could be dramatically underweight or overweight relative to an index’s natural exposure or alternatively seek to take few ‘bets’ against the underlying neutral position). As an example, the aforementioned CF Woodford Equity Income fund has almost no exposure to the Oil & Gas sector, notwithstanding the fact that BP and Royal Dutch Shell represent two of the biggest (and biggest dividend paying) stocks in the UK equity market. The prospective investor should decide if he or she is comfortable with a collective investment which takes large or small positions, relative to the fund’s benchmark, in endeavouring to outperform.
5. Professional analysts are employed to investigate the performance of funds or fund managers with a view to assessing the ‘quality’ or consistency of such returns, by reference to the amount of risk employed. As an example of the rigor applied, an information ratio is calculated (based on a ratio of the portfolio’s returns above the benchmark’s returns compared to the volatility of those returns) to determine if a manager is regularly outperforming by a little each quarter period or is less frequently outperforming by larger margins. Readers keen to learn more should investigate the Sharpe ratio, which considers a portfolio or investment’s excess return per unit of risk, as well as the notion of Alpha & Beta (Alpha indicates stock specific risk and Beta equates to overall market risk) which can shed light on a fund’s risk profile and sensitivity to the wider economy & stock market. Beyond such computer-assisted methodology, there are various financial research institutions (such as Citywire and Trustnet) which specialise in monitoring, assessing and generally publicising most collective investments’ products and performance. A search on the web will readily reveal the rating applied by such agencies to individual funds.

Finally, while the track record of a fund or a fund manager can be a useful indicator, it cannot of course predict whether good relative performance will continue in the future. In the same way that certain asset types perform better or worse, according to the macro-economic landscape and the market cycle (the perennial question of how much of that which is anticipated – in economic or company news - is already priced in?), so some fund managers perform better in certain times than others. The next article will highlight a number of the writer’s favoured collective investments and, without giving too much away, will feature at least one Exchange Traded Fund (ETF), an investment trust (a closed fund which, like an ETF, is also quoted on the London stock exchange) and an open ended fund.

David Harbage            23 February 2015