Effective Investing

by Mark Dampier

  What consumers rightly want is much greater clarity, so that they can compare the costs of funds on a like-for-like basis. The OCF has been introduced to try and help this. However, there is still a lot of argument within the industry about what should or should not be included as relevant costs. Should they, for example, include the cost of turnover within the fund (what the fund manager pays in dealing costs when buying and selling holdings)? The higher the turnover, the more it costs the fund and ultimately the consumer. It is no surprise to find that many of the very best fund managers, including many that I own, have the lowest turnover rates.

  This is an evolving situation so perhaps the best thing I can say to the reader at the moment is to do further research on the subject and try and keep abreast of any potential changes. Unfortunately my experience is that many of the articles about the relative merits of passive and active investing, while they focus on costs as a key differentiator, lack balance. This is because the argument has become a quasi-religious dispute between two sets of believers who cannot accept that the other side has a point. My advice to you is to be pragmatic, seek to understand both sides of the argument and try to get the best out of both kinds of fund.

  The need for patience

  If there is one common mistake that I would urge investors to avoid at all costs, it is becoming too impatient with the funds they have chosen. Funds are and should be seen as medium to long-term investments; and that means giving them time to do their work. Constantly chopping and changing the funds you own because they have got off to a poor start, or are going through a bad patch, is a poor strategy. You will be much better served by taking more time with your initial selections and then sticking with them. Only if a fund consistently fails to deliver what you expect over a decent period of time should you consider switching tack.

  One client recently complained to me that a nano-cap fund which has been on our list since October 2013 had done poorly. (A nano-cap fund is one which only invests in real stock market minnows, companies with a market value of less than £100 million.) I couldn’t argue that the fund had done brilliantly well, as it was up only around 6%, although it had started strongly and only petered out when the small-cap rally ended in March 2014. Yet this client sold the fund solely on the basis of its short-term track record. In my view he should have been more patient, as this is the type of fund that by its nature could suddenly return 100% in a single year. The trouble is that none of us can tell you with any certainty which year that will be. With an experienced fund manager, patience usually pays off.

  Figure 5.7: The need for patience – a smaller companies fund example.

  By way of an example, take a look at these two charts, which show the performance of two actively managed funds I have followed closely for a number of years. One is the Old Mutual UK Smaller Companies fund, managed by Dan Nickols. The other is First State Asia Pacific Leaders, managed by Angus Tulloch, a long-serving member of First State’s Asian equity team. Why have I picked these two funds? Because I think they illustrate very clearly how having conviction in a fund manager can pay handsome rewards for the patient investor.

  Figure 5.8: The need for patience – a regional fund example.

  Let’s suppose you had been clever enough to see the global financial crisis coming. You could have sold these two funds in 2007 and by 2008, as the bear market intensified, you would have been feeling very smart. Both the funds lost around 50% of their value, halving your investment – no fun at all. The chances are that if you had held these funds for more than three years, you would have been nursing a loss. But when in practice would you have made a decision to buy back into those funds? Would it have been in early 2009, which (as we can see in retrospect) turned out to be the bottom of the bear market? I very much doubt it.

  At the time, remember, many commentators could only see markets halving again. The media was full of talk of a double-dip recession and the risk of further bank failures. Confidence was at rock-bottom levels. Very few of our clients were buying anything. If you had called the bottom of the market exactly at that point, you deserve your success. My point, however, is what would have happened if (as I strongly suspect) you had remained sheltering in cash. Just look at the returns that you would have missed from that low point! Remember also that if something falls by 50% in value, and you sell out, you need to make a 100% gain just to get back to where you were.

  Yet both the two funds I highlight in the charts have rebounded by more than 250% from their lowest levels during the crisis. They are both comfortably well ahead of their previous 2007 highs. In other words, if you had stuck with the funds all the way through the painful crisis period, you would be now once again be sitting pretty. Those who hung on to their holdings in these two funds did not even have to make any tough decisions. The moral is clear: if you try and be too clever in timing the market, you will almost invariably lose out. Sadly I have seen it happen all too often. While holding your nerve in 2008 was not easy against a tsunami of bearish commentary, for most investors it would have been the right thing to do. All big stock market falls are followed by recovery. During the bad times, experience shows that, hard as it is, it is almost always better to hold your nerve, go fishing or whatever hobby you have that takes your mind off the worries of the world and do precisely nothing. The best funds will come back in the end.

  Points to remember

  The style of a fund is a big factor behind how it performs.

  The more specialised the fund, the more volatile it will be.

  Smallcap funds are riskier, but often produce higher long-term returns.

  Aim for the best funds in each sector; don’t try to pick the best sectors first.

  Always dig behind the raw performance numbers provided by your fund.

  Use charts to track the journey that a fund has made to reach its current price.

  Experience and consistency are hallmarks of the best fund managers.

  Don’t be put off if fund managers leave to start their own firms; it is often a good sign.

  * * *

  11 I have included some extracts from the information that investors can dig out online about the Artemis Income fund in the appendices.

  12 The closest the industry has come to a fund default came when a notorious fund run by Morgan Grenfell proved to be investing outside its stated investment parameters. The fund’s ultimate owners, Deutsche Bank, compensated the fund’s investors in full.

  13 I make an exception of the Woodford Patient Capital Trust, which daringly charges a performance fee but has no annual management charge at all – funny that nobody else has copied him down this path!

  Chapter 6. Building and Managing Your Portfolio

  Finding the best funds and the best managers is only one aspect of your challenge as an investor. You also have to combine the funds you like into a well-balanced portfolio that fits your own goals and constraints. You want funds that dovetail well together. In this chapter I offer my thoughts on this important aspect of the fund investor’s task and give examples of model portfolios that might suit a first-time fund investor. It picks up from where we left the subject of asset allocation in chapter 2.

  Valuation is more important than fashion

  I often hear private investors tell me that their investments have done better than professionals. I would like to think that this is true. In some cases it may be. However, those who make the claim are usually not comparing like with like. Many private investors put together portfolios that would not meet the risk constraints within which professionals are rightly required to operate, and in time this can be their undoing. They are often poorly diversified and overly-reliant on one or two individual successes that either run out of steam or can’t be replicated.

  This is often the case when markets start to fall, as they do periodically. The risks that people took to outperform on the way up mean that the
portfolio then underperforms badly on the way down. For a while those who have struck lucky start to think that they are investment geniuses, but reality has a nasty habit of coming back to bite them. This is particularly true of investors who buy individual stocks, but applies to diversified fund investors as well. Surveys in the United States have regularly shown that private investors who buy funds rarely achieve the average fund’s return (which is doubly sad as the average fund does not beat the market either). My experience in watching client behaviour at Hargreaves Lansdown over the past 15 years leads me to believe that the same pattern holds true in this country as well.

  Why does this happen? The reason is that too many investors buy funds at the wrong time, usually just after those funds have experienced a period of strong performance. Investment is a cyclical business and my belief is that the way to achieve the most consistent returns is to avoid taking huge bets on which economy, sector or market is likely to perform the best in the short term. It works better to keep a foothold in all areas of the market and concentrate instead on trying to pick the best funds in each segment. There will be times when it could be right to load up on a specific style or specialist sector – but that won’t be the point at which every other investor is doing the same thing. At any one time there are usually one or two sectors or markets that are being shunned by investors, typically those where the current news is bad, while others where the story and mood music is more upbeat are getting all the headlines and the positive fund flows.

  With hindsight, the ones you want to buy will often be the ones that nobody else wants, not the ones that everyone else does. In practice investors tend to go for the funds that are most fashionable. Yet fashions come and go, and investors rarely spot the new trends coming and go for what is making all the waves at the moment, usually with painful consequences. During the technology boom around the turn of the century, thousands of investors made and lost fortunes by chasing over-hyped internet stocks and funds, and then failing to get out in time when the sector crashed. Dull and shunned sectors such as tobacco and pharmaceuticals meanwhile came back into favour, as did my favourite equity income funds.

  Anyone who had half their money in tech funds lost out twice – first by making losses on the things they held on to for too long, and secondly by not being able to profit from the new opportunities that were going up in value while the tech sector was in meltdown. Far too few people successfully achieved the perfect outcome – riding the technology wave to its crest, selling at the top, and buying into the dip to ride the next wave, which was equity income. That is why my advice is: unless you have exceptional foresight, or are brave enough to defy consensus thinking, it is probably best not even to try and spot the next big winner.

  A more prudent approach is to reduce the number of big ‘bets’ you make on individual sectors and markets. It is better to have a broad spread of funds across a range of different sectors in the fund universe and concentrate instead on getting extra value by choosing the best fund manager in each of the main segments. That is the approach I have followed over the years in making my own investments and also where my firm concentrates its research efforts. It may not put you at the top of the leaderboard every year – there will always be someone boasting about how well they have done in Fund X or Fund Y – but you are far more likely to come out ahead over time and avoid the below-average experience of the majority of fund investors.

  Balancing risk and return in a portfolio

  Clearly, when putting a portfolio together, risk should be a factor in your thinking. Risk and return usually go hand in hand – more of one, more of the other. Unfortunately risk, like beauty, is in the eye of the beholder. It is a very difficult concept to quantify. When it comes to investment, we typically mean the risk of losing your money, or some percentage of it. But does risk of loss mean that your investment is temporarily or permanently worth less than you paid for it? The former might be a price worth paying for a superior result in the longer term, while the latter would clearly not be. An alternative approach, much favoured in academic literature, equates risk with volatility, the degree to which the value of your investment varies from one period to the next.

  Neither approach is wholly satisfactory, not least because understanding and tolerance for risk varies so much from one person to the next. It follows that all attempts to label investments as low, medium or higher-risk, while well-intentioned, can also be dangerously misleading. Take the example of a ‘low-risk’ investment, which many private investors in practice translate as meaning ‘no real risk of loss’. Gilts – government bonds backed by the full force and majesty of the UK government – are often described as low-risk, but in 1994 they had their worst year for 36 years, with the price of some very long-dated gilts falling by more than 20% in just nine months. In recent years, with interest rates at their lowest level since the Bank of England was founded, and government debt at record levels, it has also been a stretch to call them safe, since anyone who buys them at current prices faces a significant risk of losing money.

  In practice, risk has more than one dimension. Gilts are safe only in the sense that you are certain to get a known amount of your money back when they finally mature. But that does not mean you cannot lose money on them if you bought them at too high a price in the first place. And there is no guarantee that, when you are repaid, the value of the known amount of capital you get back will have the same purchasing power as when you began. In times of high inflation, the ‘real’ value of your portfolio – what you can do with the money – can be eroded very rapidly.

  Another problem is that risk, as conventionally defined, is a two-way thing. It works on the upside as well as on the downside. If you are really risk-averse, it can mean that the average return you make over the years is so low that it would have been better to keep the money in the building society in the first place. One investor who wrote to me recently pointed out that his aversion to taking even the slightest risk had cost him dearly for more than 20 years. He had come to realise far too late that what he should have done, given the length of time he knew he was going to be investing, was to go for medium to high-risk investments. That way he would have stood a much better chance of producing superior returns. The general lesson is that the passage of time can turn something which looks risky in the short term into a long-term winner.

  Diversification and risk

  The more you dig into investment literature, the more talk you will find about the benefits of diversification, which in plain English means declining to put all your eggs in one basket. That is no more than common sense – but putting it into practice is not as easy as it once was. The key to successful diversification lies in owning a range of investments that you can reliably expect to behave in different ways to each other, so that if one is doing well or badly, another is doing the reverse. What matters, to use a statistical term much bandied about by financial advisors, is whether what you own is correlated or uncorrelated. Two funds that are positively correlated will tend to move in the same direction at the same time, while those that are negatively correlated tend to move in opposite directions.

  For those who like numbers, here is table that shows you how correlated different kinds of investment assets are, based on recent experience (but be aware that these relationships can change over time). A minus sign indicates that two types of investment are negatively correlated, while a positive number suggests that they tend to move in the same direction. The closer that either number is to one (that is, +1.0 or -1.0), the greater the degree of correlation. So you can see that while the FTSE 100 index and the FTSE World Europe ex UK are highly correlated (+0.90), the same is not true of the FTSE 100 and UK gilts (-0.13). This is the argument for blending higher-risk, higher-return shares with lower-risk, normally lower-return bonds. If the stock market falls, the bonds will help to offset the impact.

  Table 6.1: The correlation between different types of investment.

 
A well-diversified portfolio will have a number of different components that tend to move in opposite directions. The table shows the correlations between various classes of investment over a recent 10-year period. A number near 1 means that two investments move in the same direction most of the time: a number near 0 implies that there is no correlation between the two, and a minus number means they move in opposite directions – making these pairs the most efficient at diversifying risk.

  Source: J.P.Morgan Asset Management.

  In an increasingly globalised world, however, markets and economies are much more intertwined than they were 30 years ago. It is harder, for example, to diversify geographically than it was. In the past, some countries’ stock markets were not so highly correlated as they are now. A big stock market fall like the one we saw in 2008 started in the United States but spread quickly around the world. The same goes for some other types of asset: those who thought they were protected by owning corporate bonds in 2008 found that in practice there was little protection there, as they fell sharply in value too. Government bonds, cash and some types of property did provide some real defensive value during the crisis.