by Mark Dampier
But I don’t like the call-option strategies that some of the income funds use to generate more income. That may increase the fund’s income in the short run, but you never know at what cost, or whether the strategy will produce negative results in the longer term. Funds that use call options have produced a lot of income but realistically there is not much capital performance to look forward to. You have to ask if they are really suitable for the people who bought them and who may well be expecting something different.
This type of fund might be okay for people in their 70s and 80s. You could argue that at that age they are equivalent to a short-lived annuity from which you can take a thumping great income now, knowing that you won’t be around to enjoy the capital after that. But would I want to do it at 55, coming up to pre-retirement planning? No, because in my view you’d be much better off with an income and growth fund at that stage.
What other professionals think
In addition to doing your own research into fund performance, there are other places where you can hope to find out more about the quality of a fund and its manager. The first and probably least useful source is to look at the ratings of funds. Fund ratings are offered by a number of specialist companies, such as Morningstar, FE Trustnet, Lipper, Square Mile and the Financial Times. Each one has a slightly different way of analysing a fund’s performance and vary in the extent to which they apply qualitative as well as quantitative scores when assessing their rating.
In the old days funds that the ratings companies liked best were simply awarded stars, with five stars the best, rather as if they were rating a hotel or restaurant. Unfortunately at the time, before the introduction of more scientific methods, they were based largely on recent fund performance. Academic research suggests that simple star rating systems of that kind tell you little about whether a fund is worth buying now. Today, while some ratings firms still employ a star system, they tend to include a lot more data, including qualitative criteria, in their assessment. The ratings have become a lot more sophisticated. Fund rating services now look at any number of risk and return measures when calculating their risk ratings and the fund’s risk-adjusted returns. The latter typically involve dividing the return a fund achieves over a certain period by the volatility (or standard deviation) of those returns so as to create a mathematical measure of risk-adjusted performance.
If you come across something called a Sharpe ratio or an information ratio in your research, they would be examples of this kind of analysis. The higher the score, the better in theory the fund. Any fund with an information or Sharpe ratio above 1.0 is said to be doing very well, while any fund whose ratio is negative is clearly doing poorly.
Why do I say that these ratings are no more than a useful starting point in determining how good a particular fund is? There are several reasons. One is simply experience. I and my research colleagues analyse a lot of the same ratios as a matter of course, but we have found that in practice they add only a little to our prior understanding of which funds are good and which ones are bad. Either they are too simple to be of any real value or too complicated to mean much beyond what you can already see for yourself in the raw performance data. However complex and sophisticated, all ratings and risk-adjusted measures also suffer from the fact that they are by definition (though to varying degrees) based on past performance data – and past performance, as we are always being reminded, is not much of a guide to future performance. Volatility of returns, although widely used as a measure of risk in financial theory, is at best a poor proxy for the real risk of a fund and at times can be positively misleading for a long-term investor. Another problem is that risk-adjusted ratios also change over time: they are not particularly stable, so a fund with a good Sharpe ratio at one point could move to a poor one a year or so later.
I suppose my conclusion to all this is: by all means have a look at ratings but never put all your faith in them. They will never be able to make up for the judgment of an experienced fund analyst.
Other useful sources
It therefore makes sense to look for guidance on which funds may be worth buying by seeking out the lists of recommended funds produced by research firms, independent financial advisors and intermediaries. The HL Wealth 150 list is an example I obviously know well, since I am responsible for producing it. The list includes our selection of the funds we like best in each of the main sectors. Other brokers also produce similar lists or reports, some of which are regularly quoted in the press. Since the Retail Distribution Review (RDR) paved the way for brokers to negotiate lower fees with fund providers, it is also worth looking around to see which advisors and intermediaries have been able to use their buying power to negotiate significant fee reductions for clients.
More often than not there can be significant overlaps between the funds that different broking and research firms recommend. This should not come as a huge surprise. Long-established fund managers with good track records, such as Neil Woodford or Nick Train, will tend to be popular with more than one research team, since most use broadly similar methods of analysis, in which past performance – whatever they may say – in practice often features prominently. In our case, we use a wide range of screening techniques to back up the information and judgments we make from our face-to-face meetings with fund managers. In particular we have developed a form of analysis that helps me to assess how much genuine stockpicking skill any individual fund manager has. That is because I believe that stockpicking skill is the key source of added value in actively managed funds.
In the bad old days before the rules changed with RDR, the situation was complicated by the fact that the choice of funds made by some brokers (not HL, I hasten to add) was heavily influenced by how much commission they stood to receive from the funds’ managers. Back in the 1990s one notorious firm of ‘independent’ financial advisors actively invited fund management companies to bid for a place on their best buy list. Fortunately the firm was detected and subsequently forced out of business by the industry regulator, the Financial Services Authority (as it was called then).
Even if you are a DIY investor, and determined to do your own research, it is probably still worthwhile to skim through the funds that the best brokers and independent ratings companies provide. If their analysis broadly agrees with yours, that should provide you with an extra degree of comfort that the fund you have chosen has been analysed by professionals and passed at least some of their basic quality tests. By the same token if you find yourself looking at or inheriting a fund that has no rating and no professional supporters, it may be tipping you off that the fund is not really as good as it might appear. Bear in mind, though, that there may be a temptation on the part of advisors to recommend the funds where the choice is easiest to defend. (You may recall the old adage that no IT manager ever got fired for choosing IBM. I dare say something similar sometimes happens in our business.)
The third place to look for guidance on good and bad funds is in the choices made by experienced multi-managers. These are funds which only buy other funds and combine them into portfolios which they then offer to clients as one-stop solutions to the individual’s fund needs. HL’s range of multi-manager funds is an example and naturally draws heavily on the research work we do for the firm’s Wealth 150 list. Jupiter’s Merlin funds, which have been run by John Chatfeild-Roberts and his team for more than 20 years, are another well-known example.
To survive for long as a multi-manager you have to really know your stuff as your investors are paying a second layer of fees on top of the underlying fees of the funds, which can only be justified by superior long-term results. As a source of information to DIY investors, the lists of funds owned by the best multi-manager funds can, however, be invaluable. It is no surprise that almost all the funds I have in my own pension fund and ISA are those that my colleague Lee Gardhouse also has in one of his multi-manager funds.
Character and personality
In chapter 4 I m
ake a reference to experience as a key factor in assessing fund managers. I would like to emphasise also how important character is. Fortunately no unit trust or OEIC has ever gone completely bust, or proved to be an outright fraud, but many fund managers have still done a poor job for their investors over the years.12 They are obviously the ones you want to avoid. Even good fund managers need watching: you want them to remain at all times aware that they are working for the benefit of investors, rather than just for themselves or their employers. It can happen that they simply run out of steam, or lose interest in going on with the job, although in my experience that is rare.
Business pressures may force them to become closet trackers or simply coast for a while, copying what the rest of the industry is doing, rather than thinking for themselves. Sometimes a fund management company may want or need to make sure a successful fund goes on taking in new money even though the fund has become too big and too popular for the fund manager to have any realistic hope of doing his job properly any longer. You always need to be on the alert for fund companies that are making asset gathering – raking in as many investors as possible – a priority over fund performance.
It can take time for a manager’s change in attitude or motivation to become apparent. I am always on the lookout for this kind of problem when we meet fund managers, which we do on an industrial scale (300 meetings a year on average). Not every fund manager is as committed to the job as Nils Taube, who famously died at his desk well into his 70s! The great fund managers are fanatics for what they do and many also have a big financial stake in their own fund and business – always a good sign.
It is important also to remember that fund managers (at least the ones that I am looking for, managing active funds) are human beings. As such they are no different from the rest of us in having different talents, personalities and temperaments. They also differ in their personal habits, objectives and motivation. The ones I like best are those who display courage and commitment when things go wrong, as they will do from time to time. The best fund managers tend to be good under fire and never lose sight of the fact that the money they are managing ultimately belongs to you; their fund should not be solely a means to enriching themselves.
The best fund managers can earn extraordinarily large amounts of money and it is only human nature that some of them tend to ease up once they have achieved a certain level of success. As an investor you need to be alive to these risks. Having said that, most of the very good fund managers I know are a bit like kids at school. They always want to be top of the form, and this competitive urge tends to keep them going long after they can afford to quit. As professional advisors, we speak to most of the fund managers on our list on a regular basis, and keep our ears open for any hint of trouble in their personal or professional lives. That is not something that is quite as easy for ordinary investors to do, although the internet can give you some of the answers.
Costs and charges
The cost of owning a fund can have a big impact on how well it does for you. Over the last few years costs have become a greater topic within the fund industry. In simple terms it is common sense that costs must affect the final outcome of your investment, so the lower the cost the better, other things being equal. But just as you wouldn’t always choose to buy the cheapest car simply because it is the cheapest, so you also need to take account of the fact that the best funds may be in a position – and justified – in charging more than those who are not so good. The critical issue is whether the result, as measured by the returns that the fund makes, more than compensates for the higher charges, taking into account also the risk profile of the fund.
Well, I hear you say, that should be relatively straightforward. But in practice it is not, because working out what the real costs of a fund are is not as easy as it sounds. One reason is that this is an area where the financial industry has hardly covered itself in glory. For many years, in the absence of a robust agreed industry disclosure standard, different companies routinely disclosed their charges in different ways, and obfuscated the figures where they could get away with it. Even now, while the industry regulator has introduced new rules on transparency and insisted on standardised reporting, there are still differences in the way that charges are set. Individual funds remain free to set their annual management fees at a level which they think the market can bear. They all charge industry professionals who can afford to buy in bulk lower fees than those you as an individual investor will be asked to pay. The amount of add-on costs that firms add to their basic management fee also varies considerably from one fund to the next.
The overall effect is that costs remain a recipe for confusion – and that is before you have to take into account some other issues that are inherent in the nature of investment, not necessarily the fault of the funds themselves. For example, if you are working out a cost figure for a particular fund, should you take the actual figure that it paid last year – or should you take the figure that is likely to incur this year? This might be quite different if the fund has grown or shrunk significantly in size over the course of a year, as can easily happen. All funds today are required to publish something known as their OCF, which stands for ongoing charge figure. It is the total amount that the fund spent on a range of specified costs in its last accounting period, expressed as a percentage of the size of the fund. For an actively managed fund, these will typically fall in the range of 0.5% to 2.5% per annum (though much less for a passive fund). But you should certainly not take that figure as gospel truth, for the reasons I have mentioned. For example, the additional costs (over and above the standard ones that the regulator has specified) charged by fund firms can range from nothing to as much as 0.3% in some cases.
The important point to remember here is that even small percentages can make a huge difference in cash terms. Just as positive investment returns start to grow exponentially to large amounts over the course of many years, so too will the ‘cost drag’ of an over-expensive fund. Over ten years, the negative impact of a 0.5% differential in fund costs can be substantial. Suppose you have two funds that both grow at the rate of 8% per annum, but one has an annual ongoing charge ratio of 1.5% and the other 1%. After ten years the difference in costs will have taken away roughly 10% of your overall gain. If you invested £10,000 in each fund at the outset, the more expensive one will have left you with £1,000 less than the other one!
So what can one sensibly say about costs? The first thing is simply to recognise that they matter, and make a point of looking at what any funds you are considering charge. Secondly, what you will find is that different types of investment fund tend to have different cost structures: in general, passive funds will (and definitely should) be the cheapest. Investment trusts and unit trusts will cost more, but their charges will be not dissimilar, although some of the older, established generalist investment trusts do tend to be cheaper than their unit trust/OEIC counterparts. Thirdly, look out for those additional costs that I have already mentioned. Fourthly, watch out also for funds and investment trusts that impose a performance fee as well as the annual management charge.
In my view, performance fees, while they may sound like a good idea, are opaque, difficult to understand and almost impossible to work out in advance, which should be enough to convince you that they are not for you. The argument you will hear for performance fees is that as they are only incurred if the fund beats a certain pre-agreed target return, they are a win-win for both investors and the fund managers. Sometimes you also hear companies say they are an added incentive for the fund managers to perform. I don’t buy those arguments at all. The one thing we know about performance fees is that you pay them if the fund does well, but they don’t give you your money back if the fund does poorly. In the most extreme cases, if the performance fees are uncapped, the investor can end up paying more than 4% per annum – try compounding that over ten years and then try justifying it! Performance fees, as far as I am concerned, are more about gree
d than anything else.13
Where I do agree is that the real litmus test with costs is whether the fund is good enough to justify above-average management fees. I suspect that the fees on the small selection of funds which I own and recommend to clients have slightly higher-than-average annual management fees, but I certainly won’t be selling them just because of that. You might think from reading the media in the last few years that the costs of funds are still very high compared to what they were years ago. The reality is that in some cases they are, but the general trend seems to be down. When I first started, most unit trusts had initial fees of 5%; for every £100 you invested, the fund took £5, partly as a set-up fee and partly to pay commission to the advisor who recommended them. Initial fees are virtually non-existent today, thank goodness. The annual fees of passive funds have also dropped a long way over the last few years. When Virgin launched one of the first All-Share tracker funds in 1996, it made much of the fact that its annual 1% management charge was cheap (which it was, but only in relative terms). Today you can buy an equivalent tracker fund for as little as 0.09% or less, so if cheap is what you want, that is the place to start.
As far as actively managed funds are concerned, they obviously charge a lot more than passive funds. The biggest change since the rules were changed in 2013 is that funds no longer automatically pay an annual commission to advisors who buy their funds for clients. Most funds used to charge investors an annual fee of 1.5%, of which half was given to the broker, advisor or intermediary who introduced the investor, and the fund management company kept the remaining 0.75%. Now funds set their own fees and investors pay whoever persuaded them to own the fund in other ways. (In industry jargon the commission payments have been ‘unbundled’ from the annual management charge.) The fund management companies now have to disclose their annual management fees directly, and though it is still early days since the new regime came into force I detect that the overall trend in fees seems to be gradually down.
