Effective Investing

by Mark Dampier

  Points to remember

  Investment funds pool your money with that of other investors.

  They are the simplest and most convenient way for most people to invest.

  Always look to make use of all your available tax allowances and exemptions.

  You only need a handful of funds to meet all your investment requirements.

  Costs and charges are important factors to take into account.

  There are a number of traps for the unwary first-time investor.

  A good platform will do most of your admin for you and save a lot of time and hassle.

  * * *

  4 I cannot know that for certain. To be sure I would need to know your personal circumstances, your relevant knowledge and experience, and your tolerance for risk. However, the generalisation remains valid.

  5 As I said earlier, the amount of information private investors now have access to is as good as most professionals had 20 years ago, but professionals still have the edge.

  6 There is no guarantee that these reliefs will still be available in the same form in future, as the rules and limits are changed by the chancellor almost every year.

  7 It is true that some funds choose to restrict inflows from new investors when the management company decides it has become too big to continue their investment strategy successfully. That is normally a positive sign, as it means they are putting your interests above their own short-term profitability.

  Chapter 4. Narrowing the Field

  So you have completed your financial plan and decided to begin your new investment programme. Let’s say you are planning on putting aside £1,000 a month for the next ten years. You have set up an ISA to allow you to do it without having to pay any tax on the income and capital gains. Having considered all the pros and cons, you have decided, like me, that you are going to use funds rather than invest directly in individual equities and bonds, or in more complex alternatives such as investment trusts. Great! Now it is time to turn your attention to which funds are going to best suit your purpose. This is where you will immediately run into the first of the major challenges that any self-directed investor faces. It is not going to take you more than 20 minutes of research to discover for yourself what most investors soon find out for themselves – that the choice of potential investment funds out there is simply bewilderingly large.

  Deconstructing the universe

  If we look at UK-registered funds alone, there are 3,000 funds you can choose to buy. Globally at the last count there were 90,000! Yet a well-balanced portfolio rarely needs more than ten or 15 funds in it. This universe therefore needs some serious pruning. One of the curious statistics about the UK fund industry is that there are more UK funds investing in listed company shares than there are listed company shares for them to invest in! That is before you consider what are called offshore funds, those registered in other countries and domiciles. What is more, each fund is likely to have more than one different class of unit or share to invest in.

  At this point some people either have a tendency to give up or simply plump for any name that they recognise. High street banks, for example, have always put their name to a range of funds for this very reason. They don’t actually manage the funds themselves, but outsource that task to a specialist investment management firm, keeping a share of the profits on the sale for themselves. Some of the big retailers, such as Marks & Spencer and Tesco, also offer funds to their customers in the same way. There are also (inevitably, you might think) Virgin funds as well. Richard Branson was one of the first to try and muscle in on the growing demand for funds back in the 1990s, when with great fanfare he launched his own fund, which in practice, like most of his branded ventures, was managed by another company.

  Unfortunately there is no guarantee that a branded fund will offer good value. Brand recognition in an unrelated field is not itself a recipe for investment success. Good funds are best found through independent research. The idea that investors would value independent help in choosing which funds to own was exactly the reason that Peter Hargreaves and Stephen Lansdown first set up their business 33 years ago. It was also, as I have mentioned, how I started out in the business myself with Kean Seagar at Whitechurch Securities. We all quickly found out how popular trying to help people through the minefield of choosing funds could be. If choosing the best funds was an easy task, firms like HL and many others would not exist.

  Nevertheless there is no reason why investors should not be able to do a good deal of the homework themselves – and good reasons why, even if you end up going along with a firm’s recommendations, or are merely trying to see what your financial advisor or wealth manager is doing with your money, making the effort to understand what makes the difference between a good and a bad fund will greatly improve your chances of success.

  First steps

  The first step in narrowing down your choices is to get a feeling for the different categories of funds available to investors. The fund industry’s trade association, the Investment Association, categorises funds in two main ways: by the type of investments they make and by their investment objective. The main categories are set out in the next figure. Most of them are largely self-explanatory, although the differences between some of the equity classifications take a bit more digging into.

  Figure 4.1: The categories of investment funds.

  Source: The Investment Association.

  The first cut, shown in the top line of the chart, is determined by the primary objective of the fund: is it to generate income, capital growth or some other objective? Growth and income are pretty straightforward. Capital protection refers, broadly, to cash or cash equivalents. The specialist category includes funds that invest solely in property, technology and telecommunications. Only a relatively small number of funds fall into those categories.

  The next level of classification describes whether, within these categories, a fund invests primarily in equities (shares), fixed income (bonds), or some combination of these asset classes (mixed assets). Funds are also classified by whether they invest primarily in UK-listed shares and bonds or in overseas markets. Each of these categories can then be further broken down into more specific types, e.g. funds that invest solely in one country (say India) and those that invest in regions (e.g. North America or emerging markets). The fixed-income sector also has a number of different categories, depending on the kind of bond that the funds mainly invest in.8

  If you go to the Investment Association website you can also find out how many funds there are in each category and how much money is invested in each one. For example, you will discover that around 54% of the money invested in funds goes to pure equity funds, while fixed income accounts for 15% of the total and mixed-asset funds, which combine equities, bonds and property, another 12%. The remaining funds are property, cash and specialist funds.

  Within the equity-only category, just under half of investors’ money is invested in funds for whom UK stocks are their predominant focus. Global equity funds account for a further 21% while the remainder cover specific regions or countries. In fixed income the great majority of funds invest only in sterling-denominated bonds of one kind or another – with corporate bonds (issued by companies) and gilts (bonds issued by the UK government) the two largest segments.

  This is the universe from which your initial choice of fund will be made. It is probably worth your while taking a few minutes to look through the definitions on the Investment Association for each category. You will pretty quickly get a reasonable picture of what is available. If the bad news about funds is that there are too many to choose from, the good news is that you can be sure that somewhere in there will be one or more funds that are ideally suited for your purpose. My job is to help you find them.

  Active and passive

  Two important distinctions need to be made at this point. The first is between ‘actively ma
naged’ and ‘passively managed’ funds. An actively managed fund is one where all the investment decisions are made at the discretion of an individual investment manager, using his or her professional knowledge and experience to decide which investments to own in the fund.

  A passively managed fund, in contrast, is one whose choice of holdings is determined by a pre-set formula, designed not to beat a particular market’s performance but to match it. For example, a UK tracker fund would aim to replicate as closely as possible the performance of the FTSE 100 or FTSE All-Share Index.9 These funds are run by computers according to a pre-set formula with only a tiny amount of human oversight.

  Passive funds come in two main forms. The first are conventional unit trusts/OEICS which simply track a given index. Like all open-ended funds, the units are issued and redeemed by the fund provider, with orders executed on either a daily or (less commonly) a weekly basis. The second kind are known as exchange-traded funds, or ETFs for short. Unlike conventional tracker funds, these can be bought and sold just like a share in the secondary market, which makes them of interest to traders as well as long-term investors. ETFs typically offer an even wider range of choices than conventional funds, giving investors a wide variety of options for tracking individual market sectors (e.g. telecom or pharmaceutical shares as a group) as well as broader stock and bond market indices.

  Having said that one of the main reasons for choosing an investment fund is that it gives you access to professional investment skills, it might seem odd that people invest in funds run by computers. Thirty years ago nobody would have thought that it made any sense at all. But times change and it is very much part of modern investment practice.

  The awkward fact remains that there is some overwhelming evidence that most professionally managed funds don’t do as well as they should. Thousands of studies have shown that if you measure how investment funds perform in aggregate, the average fund in any sector fails to do anything like as well as you might expect. By that I do not mean that the funds fail to make money – most do in the end, at least if you own them long enough. What I mean is that most funds fail to beat what experts regard as the appropriate benchmark for measuring their success or failure.

  If a fund is investing in UK shares, for example, it is reasonable to suggest that over a period of a few years that fund should make more money than the UK market for shares, on average, has done. Since you can now easily buy a passively managed fund that will closely replicate the UK stock market index at relatively little cost, there is no point in paying more for an actively managed fund with the same objective if it then fails to do as well. This so-called ‘benchmark’ test is one that applies to all kinds of funds, whatever their investment style, and wherever they happen to choose to invest. (A North American fund should be compared to a North American benchmark, a Japanese fund to a Japanese index, and so on – that is what ‘beating the market’ means.)

  So why do the majority of funds fail to beat their respective benchmarks? Surely any professional should be able to do better than the market average? One reason is that the costs a fund incurs when the manager actively chooses investments are much higher than if a fund is following a passive strategy. Those costs are ultimately paid for by the fund investor and reduce his or her return. So even if the manager does succeed in matching his benchmark, the costs incurred may still mean that the investor in the fund is no better off at the end of the day.

  Another reason is that every fund that beats the market average has to be matched by one that does not. That is just a simple fact of life, because managing funds is what academics call a zero-sum game. Not everyone can do better than average. I comment further on this important issue in chapter 8. While passive funds certainly have their uses, I believe that the case for choosing actively managed funds still remains very strong, provided of course – and this is the important caveat – that you really understand how to pick the best ones. If you don’t feel able to do that, then a passive fund is worth looking at as a sensible alternative.

  Income or capital?

  A second important distinction that comes out of the Investment Association classification is between funds whose primary objective is capital appreciation and those whose primary objective is generating annual investment income. Most types of fund in practice pursue a mixture of the two, and over time you will hope to get both income and capital gain from your fund. In fact, I believe that you should always think about funds in terms of what is called their total return – the combination of income and capital gain that they are likely to produce.

  Nevertheless it is important to be clear what level of income any fund you are considering is likely to produce. Funds pay income to investors in the form of a dividend, typically twice a year.10 The fund’s yield is a figure that shows what percentage of the value of a fund is paid out as dividends each year. A fund that pays out £5 a year as dividends for every £100 invested in it is said to have a yield of 5%. This is important when deciding in which sector a fund should be classified. For example, the requirement for a fund to qualify for the UK Equity Income sector is that it should have a yield which is at least 10% higher than that of the stock market as a whole, as measured by the FTSE All-Share Index.

  So if the stock market’s aggregate dividend yield is, say, 3%, then the income fund needs to pay out at least 3.3% to qualify (110% of 3% is 3.3%). We can say that an equity income fund, therefore, is aiming to pay more in the way of income each year than the stock market as a whole pays in dividends. The flip side of this, however, is that this higher income return may come at the expense of a slower rate of capital growth.

  In practice many funds allow you some choice in how you take the gains that your fund makes. They do this by offering you a choice between income and accumulation units. As their name suggests, income units pay you out any income that the investments have generated in the course of a year. Accumulation units on the other hand take the income you could have received and reinvest it in the fund itself on your behalf. That way you are effectively voting to make growing your capital, rather than generating income, your priority. You can always switch from one type to another as time goes by.

  Tag confusion

  It is easy to be confused by the fact that funds may have more than one class of unit. This problem arises because fund companies are willing to charge lower fees to professional firms who buy large amounts of units. For some reason fund firms give different labels – usually a single capital letter – to these different kinds of unit. There is no standard method of classification, so one company will tag their retail units with, say, the letter R while others will use B. Don’t ask me why! Following a change of industry rules in 2013, you also need to distinguish between ‘unbundled’ and ‘inclusive’ funds. Where you can see a choice between the two, go for the ‘unbundled’ one, as it will be cheaper. This kind of fund does not automatically include the payment of commissions to advisors and other intermediaries, which was standard practice before the rules were changed.

  Criteria for classifying funds

  Lets go back to the basic breakdown of funds by type. A quick analysis shows that two thirds of UK-registered funds on offer to investors are funds that invest predominantly in the UK equity and bond markets. That also makes it a logical place to start for any first-time investor. This is not because the UK stock market is a particularly strong reflection of what is happening in the UK economy. On the contrary, many companies listed on the UK stock market – especially the larger ones – are global businesses that only carry out a fraction of their business in the UK.

  Nevertheless the UK market is a good place to start, for both equities and bonds. Among other things, UK funds are always priced in sterling, which means that you have no need to worry about movements in exchange rates when deciding where to invest. As a general rule it makes good sense, I believe, to start your investing career in your home country. Once you have started out, gained some exp
erience and have seen how you are faring, then it could be time to start looking further afield.

  My main piece of advice at this stage is simply that it is more important to pick the best funds in whichever sector you choose to look than it is to try and base your decisions on picking the best sectors first and then finding the best funds in each one. This raises the question of what makes a good and a bad fund. This is the $64,000 question. Identifying a good or a bad fund is not a simple matter. There is no single factor that makes one fund good and another bad. Rather it is a question of looking at a wide range of different criteria and forming an overall judgement as to which ones best serves your purpose and your appetite for risk.

  Here are some of the factors that I think should be at the forefront of your mind when you are trying to make a judgement about funds. I return to each of these topics in more detail in the next chapter.

  Performance

  How much money has the fund manager made in the past? Clearly this is an important factor, but not on its own decisive, or even the most important thing to think about. There is a reason why regulators insist that every fund advertisement has to say in bold letters that “Past performance is no guide to the future”. It happens to be partly true. Performance is just one of several factors to take into account. You have to analyse the track record of a fund very carefully before you can assume that it will continue to do as well. Good performance in the recent past may only mean that a fund manager has been lucky. When driving, looking in the rear-view mirror is necessary, but you wouldn’t want to rely solely on what you can see behind you. It is the same with investing in funds.