Chapter 19

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Choosing Investments

Investment selection

‘Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.’

Warren Buffett

So far, our focus has been on top-down asset allocation. It is probably the most important investment decision you will make, determining the preponderance of your portfolio’s return and risk. However, choosing bottom-up investments makes a big difference.

After setting your asset allocation, the next step is selecting investments under each asset class. Choices are sometimes bewildering. For example, you decide to allocate 20% of your portfolio to UK equities. You can choose individual UK stocks, a passive index tracker or an ETF, an active fund or blend a number of the above. Each choice has different consequences in terms of return, risk, fees and efforts.

Investment selection can make the difference between success and failure in achieving your financial goals. Do not neglect it.

This chapter is dedicated to selecting investments. We review some choices between passive, active and hybrid funds and propose a framework for selecting actively managed funds. In the next chapter we will go over various investment vehicles and their costs. Understand what you buy and why you buy it.

Funds versus individual securities

When selecting investments, first choose between individual securities and funds.

A fund (collective investment scheme – CIS) is an arrangement enabling numerous investors to pool their assets so they are invested and managed by an independent fund manager on their behalf. By pooling assets, investors benefit from economies of scale and professional management.

For example, you have £500 to invest. When selecting individual stocks, you can buy a limited number of stocks since each stock’s price ranges from about £1 to £75. So, your diversification is narrow.

Some brokers charge £100 or more per year for holding securities on your behalf in addition to a fee when buying securities. Some charge a percentage of the value of traded securities, but with a certain minimum. Others do not charge for holding securities once you have paid a dealing commission.

Say your dealing commission is 1% or a £20 minimum. Had you traded £10,000, you would have paid £100, which is 1%. But, since you trade £500 you pay £20, which is a massive 4%.¹

And you need to pick the stocks yourself as £500 is not enough to pay for professional advice.

If, however, you invest your £500 in a fund together with other investors, it can buy many stocks, diversifying its holdings. All investors share transaction costs, making them a much lower proportion of each investment.² And a professional fund manager, picking stocks for everyone, manages the fund.

The Financial Conduct Authority (FCA) in the UK regulates certain funds. Regulated funds include authorised UK schemes and recognised offshore schemes. Unregulated funds are subject to restrictions on marketing and are not usually open to investment by retail customers. Your platform is likely to include authorised funds. Managers of authorised funds must follow strict rules about risk management and disclosures.

Most long-term savers use funds. Some buy individual securities. However, unless you are committed to researching individual securities and you think you have a skill to select the right ones, investing through funds is the recommended approach.

Active funds might be more expensive than securities, due to fees, but you get better diversification and professional fund management. Index trackers offer diversification at a reasonable price.

Instead of choosing individual securities, spend most of your time saving in ISAs and pensions, dealing with property, formulating an appropriate investment strategy, thinking about asset allocation and investing via funds.

Active versus passive

Your next investment selection choice is between active and passive funds. As always, each choice has advantages and disadvantages.

Active funds

Active funds aim to generate alpha in excess of their benchmark. Fund managers select investments, constructing a portfolio different from the benchmark.

Active management’s first advantage is potential alpha. Alpha is precious. Adding some return to your portfolio can have a large impact, in particular over the long term.

Active management’s second advantage is risk management. Professional fund managers can control risks, especially in risky asset classes such as high yield, emerging market debt (EMD) and emerging market equity (EME).

For example, managers can avoid buying bonds with high chances of default and stocks of companies in financial distress. The caveat is that if these bonds do not default and these companies make it through, their securities’ price can rally.

Active management’s third advantage is unconstrained investing. In funds allowing managers flexibility, such as some multi-asset funds, managers can enhance returns and mitigate risks, benefiting from a wide investment opportunity set. Managers are not tied to a benchmark, which dictates a large portion of performance.

Skilled managers can add value when given freedom. An added benefit is that you can learn from your multi-asset fund managers, using their insights to manage your portfolio. Most active funds, however, are tied to a benchmark through tracking errors and limits.

Nevertheless, like everything with investing, every decision has its pros and cons.

Active management comes with a number of disadvantages; the first one being fees. Active funds are generally more expensive than passive index trackers.

Management fees can range between 0.50% and over 1% per year. It depends on the asset class and fund manager’s style and reputation. However, investing in an expensive star fund manager, who delivers, can be money worth spending.

High costs could be another disadvantage, depending on portfolio turnover. Portfolio turnover measures the frequency of buying and selling investments.³ A 100% portfolio turnover or more does not necessarily mean all securities were changed, but it is a high turnover strategy. A low turnover of about 20% to 30% indicates a buy-and-hold strategy.

Active management involves trading securities. Ever changing markets and market views lead managers to reposition their portfolios. A manager with a short investment horizon might buy and sell securities frequently, generating transaction costs. A manager with a long investment horizon, buying and then holding securities for a long time, may have a low turnover.

You might not even see the trading costs. Unlike fees, that should be disclosed, transaction costs are netted from performance.

Given fees and costs, active managers face a high hurdle to pass to generate net alpha. Most of the time, the average manager underperforms the benchmark (manager risk) because of fee and costs, as well as due to bad investment decisions.⁴

The probability of success of aggregated active management does not solely rely on manager skill. Skill is a prerequisite, but the specific time period, general market conditions and the type of asset class influence the chances of success.

To outperform a benchmark, managers need divergence in performance of individual securities (high cross sectional volatility and low average correlation amongst securities).⁵ If all securities move in a similar way, it is difficult to pick any that outperform the general market.

For instance, when markets rally strongly, like they did at the end of the 1990s, across different sectors and securities, managers are more likely to lag the benchmark. However, when markets move sideways or downwards, performance of securities tends to diverge, increasing the chances of managers’ success.

Another dimension of success is market leadership. Narrow leadership means a small number of securities drive the entire market’s performance. The odds are lower for managers to select the right ones. For example, when Apple and other IT stocks perform strongly, they can take the entire US equity market with them. Many managers underweight Apple just because of its sheer weight in the index. When it outperforms, their relative performance may suffer.

Broad leadership means a large number of securities outperform the market, increasing the likelihood of managers picking the right ones. In the FTSE 100 Index, for example, about 40% of the total index’s weight is concentrated in the largest 10 mega-cap stocks. When they lag the benchmark, managers can select from the other 90 smaller stocks, having a better chance of outperforming.

Managers’ probability of success depends on the characteristics of each asset class. Efficient markets are deeply researched. It is harder to locate mispriced securities. For example, the US large cap equity market is highly efficient, making it tough for active management.

Inefficient markets are less researched. More securities may be mispriced. For example, the EMD and EME markets are not as efficient as their developed peers. However, managers need extensive resources researching securities in these markets since transparency and disclosure standards might be weak.

Managers need markets to be neither completely efficient nor completely inefficient. If a market is too efficient, security prices do not diverge from value, so investment opportunities are rare. If a market is too inefficient, security prices do not converge with value, so investment opportunities are rare as well. It needs to be not too hot and not too cold.

Market breadth measures the number of securities in the market. A small number of securities offers limited opportunities for security selection. For example, the UK gilt market is a narrow market, including about only 40 bonds. On the contrary, the global IG credit market spans thousands of securities. Breadth offers choice. Choice presents managers with more levers to pull to add value.

The Fundamental Law of Active Management validates the importance of breadth.⁶ According to the law, information ratio is a function of information coefficient (skill or correlation between decisions and successful results) and breadth. Breadth is the number of independent investment decisions per time period. You need not only to make more good decisions than bad ones, but also to make many decisions.

The secret for successful investing in active funds is a skill to select outperforming managers. Whilst many investors rely on past performance to select winners, it can be inconsistent. Past winners might be future losers and vice versa. Manager selection should differentiate between repeatable skill and unrepeatable luck.

Select active funds only if you think a fund is likely to generate alpha, justifying its fees, and you have the skill to select funds that are likely to deliver. Alpha is valuable and can make a difference. It can be worthwhile to make the effort to research active funds. But if you cannot commit or do not believe you can select successful funds, go with passive index trackers.

Passive index trackers

‘I’d compare stock pickers to astrologers, but I don’t want to bad-mouth the astrologers.’

Eugene Fama

Passive index trackers aim to track the index’s performance. They are called passive, since they do not use active management trying to beat the index. Rather, they use different methods to replicate the index’s performance. Do not expect them to outperform or underperform. Doing a good job, they should perform in line with the index.

Trackers offer a number of advantages. Using trackers to implement your asset allocation is simple and diversified. They replicate the performance of broad markets, without concentration in a small number of securities. Active funds, on the other hand, are usually concentrated in a portfolio of 30–40 holdings.

Trackers have modest tracking errors relative to indices used in SAA. A portfolio of trackers should match the SAA more closely than a portfolio of active funds.

Trackers eliminate manager risk. Human error is not a severe risk when the index tracker’s provider is experienced and reputable.

Trackers are less expensive than active funds. The turnover of trackers may be lower. They have some turnover, however, as securities are added to and deleted from indices (index rebalancing).

Fund size is not a concern. Active funds becoming too big may close to new investors – too much money chasing too few opportunities. Large amounts might move the market when traded (market impact). Trackers have bigger capacity than active funds.

Often, trackers offer better liquidity than active funds due to their size. Implementing short-term views using trackers may be superior to active funds since active managers need time to generate alpha.

Finally, trackers’ net performance can be better than that of the average active manager during some time periods, when active management struggles.

Trackers also have disadvantages – nothing is perfect. You need to understand the replication methodology. Trackers using derivatives, such as swaps, can have counterparty risk.⁷ However, providers use a number of techniques to reduce counterparty risk (such as diversifying counterparties, over-collateralisation and covenants).

Some trackers use securities lending.⁸ Check the risks of securities lending and whether a share of its revenues is reflected in performance.

Trackers, by definition, underperform the index because of fees, albeit small. Securities lending can improve performance.

Some trackers might have a tracking error with the index. It depends on the replication methodology, fees, costs and the provider’s experience.

So what should you choose?

Your choice between active and passive focuses on three main factors:

1. Your skill in selecting active managers and the effort you are willing to spend on selection – having skill means active is an option; if lacking skill, go passive.
2. Your fee budget – the fee you are willing to spend on active funds.
3. Some asset classes should prefer active management (such as high yield and EMD) or they cannot be tracked (such as direct property).

Using active funds requires a commitment. You need to research, select and monitor them. Trackers also require commitment, but it is far less than that needed for active funds.

The choice of active funds in your ISAs and pension is another dimension. If you can access only unattractive active funds, then passive funds may be your only option.

Importantly, trackers usually track market-capitalisation indices that have some shortcomings. One solution is smart beta strategies.

Smart beta

Most indices (such as FTSE 100, S&P 500) follow a market-capitalisation (­market-cap) weighting scheme. The weight of each security is the product of the number of outstanding securities and its price.

For example, company A has one million outstanding stocks with a price of £10. Its market capitalisation is £10 million. Company B has two million outstanding stocks with a price of £15. Its market capitalisation is £30 million. A market-cap index with stocks A and B as its constituents has a 25% weight in stock A and 75% in stock B.⁹

Market-cap indices suffer from a number of weaknesses. Large cap companies have material weights in the index, which might have a concentration in the largest stocks. For example, the weight of the top 10 stocks in the FTSE 100 Index is nearly 40%. Whilst the index seems to be well diversified across 100 stocks, the top 10 drive a large portion of its overall risk and return.

Furthermore, the FTSE 100 Index has high concentration in a number of sectors, such as oil & gas and banks. A banking crisis or a drop in global commodity and energy prices, for instance, can especially hurt the UK equity market.¹⁰

IG credit indices are concentrated in financials and utilities. For example, before the 2008 credit crunch, tracking a corporate bond index heavily exposed investors to financials, which plummeted in the crisis.

Tracking market-cap indices seems like a good way to diversify. However, concentrations might be lurking underneath.

The exposure of market-cap indices to sectors changes over time. Indices can amass an increasing exposure to sectors whose value undergoes rapid appreciation. Commonly, it happens during the build-up of bubbles, just before they explode. For example, before the 2000 high-tech bubble burst, the IT sector’s weight surpassed 30% of the S&P 500 Index. It ended in tears as technology stocks crashed.

Market-cap indices are exposed to unrewarded risks. One risk factor attracting a risk premium is small caps, not large caps. Growth stocks have a large weight in indices since their price has appreciated recently and so has their weight. However, value stocks tend to outperform growth stocks.

IG credit market-cap indices tend to have a large exposure to the most indebted companies, since they issue a large amount of debt. However, leveraged companies can also be the riskiest.

Smart beta strategies aim to address the shortcomings of market-cap indices by following a different weighting methodology and systematically exposing the portfolio to rewarded risks, normally by following a rule-based strategy.¹¹

Whilst discretionary management is based on fund managers’ decisions, rule-based strategies follow a set of rules that can be systematically implemented in portfolios. For example, a rule could be reducing exposure to the IT sector when its weight reaches 15% by selling proportionally all the securities in it.

Smart beta strategies sit between active and passive. They are not active as they do not aim to add value through discretionary security selection. And they are not passive since they do not blindly track market-cap indices. Their fees should be lower than those of active, but higher than those of passive.

Some smart beta strategies aim to control risks through diversifying and avoiding concentrated exposures. For example, some strategies diversify the portfolio equally across sectors or equally across securities (equally weighted). Such an index may have large exposure to small cap securities. Others aim to enhance returns by tilting the portfolio to rewarded risks, such as quality, size, momentum, value and low-beta stocks.¹²

Credit smart beta strategies can reduce transaction costs by following a buy and maintain philosophy – purchasing securities and holding them to maturity without good reasons to sell them, such as imminent default.

Selecting smart beta strategies requires due diligence. They have become popular. The choice is plentiful and diverse in terms of construction and philosophies. Some strategies are better than others. Some are completely quantitative, based on past trends and market behaviours that might not continue into the future. Not everything labelled smart beta is necessarily smart.

The investment spectrum

The investment spectrum describes the array of different strategies, ranging from passive index trackers, through enhanced indexing and smart beta strategies (hybrids), to active funds.¹³

In enhanced indexing strategies, fund managers take a relatively low tracking error, aiming to add a relatively small alpha. Usually, it should come with lower fees relative to full-blown active funds. Fee level should be proportional to the level of expected alpha.

By blending investments from across the investment spectrum, control your portfolio’s overall fee, diversify different management styles and align your investments with your investment strategy.

Relative versus absolute return strategies

Relative funds aim to beat an index. Its performance determines a significant portion of their performance. The fund manager aims to add alpha, usually with a tracking error constraint against the benchmark. When paying for these funds, you are paying for both beta and alpha. However, you can get beta return cheaper through index tracking.

Absolute return funds are normally benchmark-agnostic. They target a return irrelevant to any index. These strategies can target investment objectives that better fit yours. Increasingly popular, they offer lowly correlated returns with equity and bond markets, which make the majority of most portfolios.

Whilst they may offer more alpha than beta, many funds still rely on beta returns. However, most, absolute return strategies’ performance should depend more on manager’s skill than on market returns.

When a fund does not follow a benchmark, classifying it in your portfolio is challenging. For example, a market neutral long/short equity fund may have a distinctly different return from that of the equity market. Putting such a fund under equities in line with your SAA may be mismatching. You are investing in a manager’s skill, not in the equity market.

Managers of relative and absolute strategies have different perspectives on risk. Stating the obvious, relative managers focus on relative risk, whilst absolute managers focus on absolute risk.

For example, when expecting an equity market crash, relative managers may hold more cash (usually up to a 10% maximum in long-only funds) and invest in defensive stocks. But they will not increase tracking error with the index beyond their limit. They aim to outperform the index when it falls, not avoid the fall.

Absolute managers, on the other hand, may move big portions of the portfolio to cash and bonds to protect the downside, as well as buy downside risk protection instruments, such as put options. They do not have a tracking error, limiting them when aiming to manage downside risk. They want to avoid or mitigate the fall. But this means that if they get it wrong, they might lag the equity market.

Absolute versus target return

Absolute return often refers to strategies aiming to generate a positive return every year, independent of market conditions. For example, even when the FTSE 100 Index falls by 10% in a year, an absolute return strategy still targets a positive return.

This sounds wonderful. However, such absolute return strategies depend entirely on a fund manager’s skill, they are typically expensive and they might not achieve their goals.

A target (total) return strategy usually aims to deliver a certain return but over a number of years, such as three to five years, typically reflecting a full economic cycle. Such a strategy does not aim to deliver a positive return every year.

The two types of strategies require a different mindset from managers. Absolute return typically uses derivatives, leverage to amplify small profits and high frequency trading. Based mostly on relative (pair) trades, it uses long/short positions to neutralise some of the beta exposure to market movements.

Target return typically uses physical investments (not solely derivatives), leverage is less common, and its trading frequency is not as high as that of absolute return. It can have more exposure to market returns.

Do it yourself or multi-asset funds

Another choice is between single asset class funds, investing in equities, bonds or alternatives, and multi-asset funds, investing in a blend of asset classes.

A substitute to designing your own investment strategy or changing it based on different phases of your life cycle, is investing in Diversified Growth Funds (DGFs) or target date funds (TDFs). You outsource your portfolio’s management to an external fund manager.

Most DGFs are dynamic multi-asset funds, targeting a return broadly in line with your investment objectives, such as cash +4%. They can come with different names than DGF, but the principle is similar. You can control the DGF’s return and risk by blending it with cash, bonds and equities.

For example, reduce the return and risk of a DGF with an objective of cash +5% to cash +3% by allocating 60% to the DGF and 40% to cash. The expected return of the mix is cash +3%.¹⁴

Blend a number of DGFs to control their overall return and fees, as well as diversifying manager risk.

DGFs could be a viable choice. Nevertheless, even when using DGFs, plan for your retirement and dynamically control the blend of DGFs according to your changing investment needs.

Mostly common in the USA, target date funds (lifestyle funds) basically aim to do the dynamic investment strategy for you throughout the different phases of your journey to retirement.¹⁵

Each set of funds has a target retirement year. You should invest in a fund whose target date is close to your retirement. Most funds invest in growth assets during the growth stage. Then, they gradually and automatically move to a mix of gilts, inflation-linked gilts and cash, assuming investors buy an annuity and take a 25% cash lump sum when retiring. Effectively, you outsource managing your glide path to the fund.

With pension freedom, lifestyle funds need adapting, as more people are likely to retire in stages, continuing to invest after retirement.

The main advantage is simplicity. You do not need to do anything; a professional manager is doing everything for you. You buy a single fund and that is it.

The main disadvantages are that the fund may not match your particular needs; the fund lacks flexibility and it does not adapt to changes in your circumstances (such as deciding to postpone retirement); the glide path is automatic (without considering market conditions); fees may be toppy; and manager risk – you hand over your financial future to a single manager. If you invest in TDFs, diversify across a number of funds from different providers.

Information on funds

After deciding which types of funds to use (active, trackers and so forth), the next step is gathering information to select funds within chosen types.

Two online sources with free information on funds are:

1. The Investment Association (IA) at www.theinvestmentassociation.org.
2. Morningstar at www.morningstar.co.uk.

The IA categorises funds in IA Sectors, principally according to the assets in which each fund invests, as well as geographic focus. Some sectors emphasise investment strategies. The sectors are helpful to compare funds. For example, you can screen funds by UK Smaller Companies, Global Emerging Markets Bond or Mixed Investment 40–85% Shares.

Morningstar lets you search funds according to criteria, including asset class (Broad Category), IA Sector, Morningstar Rating and Morningstar Analyst Rating.^16,17 For each fund you can view a report, showing performance, key stats and a basic Morningstar analyst report. Register for free for access.

These online resources make it easier to analyse and select funds. In addition, you can readily download each fund’s factsheet, which summarises key information on the fund.

Fund selection based on past performance

When selecting funds, selectors often tend to focus solely on past performance, choosing funds with good recent results. This approach has two concerns.

First, understand the performance. Differentiate between the underlying index’s performance (manager’s style) and the manager’s added value. Check whether relative performance was due to security selection or the manager’s style being in or out of favour.

For example, a manager with a value style tilt can show strong performance when value outperforms, not because of skill in selecting securities. The manager might have been lucky, not smart.

The second concern of basing selection on past performance is that performance is in the past. You buy a fund today because you believe it will outperform in the future. Past performance is not, necessarily, indicative of future results.

Grounding decisions on past returns is backward looking, not forward looking.

When selecting managers, try to qualitatively understand how they manage money to ascertain whether past performance is likely be repeated in the future. This is not a simple task.

Being pragmatic, it is more undemanding to focus on past performance when selecting funds than to conduct a full-blown manager due diligence. It is relatively easy and does not require extensive research.

When selecting a fund, it should have:

1. A long-term record of outperforming the benchmark (over 3 and 5 years).
2. A recent short-term record of outperformance (last 12 months).
3. An incumbent manager who has been managing it for a number of years.
4. A top-quality Morningstar rating of 4/5 stars and gold/silver/bronze.

A fund meeting these criteria is most likely a good, best-of-breed fund. Plan to hold it for the long term (5–10 years), allowing its manager time to generate superior returns.

Due diligence process – 6P

When choosing active funds, the 6P due diligence process ensures you consider all relevant angles. Some Ps are also relevant when choosing trackers.

The process goes over all the qualitative and quantitative factors to consider, namely:

1. Platform.
2. People.
3. Philosophy.
4. Process.
5. Portfolio.
6. Performance.

Platform

Platform refers to the organisation (asset management firm) offering the fund. It considers the reputation of the organisation, its size, track record, domicile, resources, depth and breadth of experience (investment teams and operational staff), compensation structure and client base.

Since you are not a full-time manager selector, limit your choice to well-known trustworthy firms. Identifying niche players, which may have interesting potential, is demanding, requiring considerable research. It is safer to select top-tier, renewed asset managers. Check their website for information, including assets under management (AUM). Firms managing over £100 billion are quite large. Consider their funds’ performance. If they offer a range of funds across different asset classes with good performance, it indicates the firm is successful.

People

People are the fund managers and support teams. When entrusting your money to people, you need to trust them. Every fund, whether it is based on a fundamental judgemental or a quantitative process, depends on people.

Search for good or bad news concerning fund managers. Choosing seasoned fund managers with a proven track record and reputation is prudent when having limited capacity to research the team. A risk with a star fund manager is a key person risk. If the star leaves, the fund is in jeopardy.

Ensure the fund manager has been managing the fund for a while. Unless it is a truly team-based process, confirm the fund’s track record belongs to the current manager.

Philosophy

Philosophy is the manager’s beliefs on how value is added. Do you buy into the philosophy?

Managers have different approaches to adding value. Some believe in fundamental analysis, calculating the intrinsic value of securities and buying or selling when value deviates substantially from price. These managers invest in research, analyse financial reports and industry trends and meet managements of companies.

Believing markets are not entirely efficient, they think they can take advantage of mispriced securities. Often, they use judgement, intuition and subjective gut feeling.

Some ‘fundamental’ managers base their ‘research’ on tips from brokers and relative valuations, such as P/Es – hardly fundamental and hardly research.

Some managers use technical analysis. Typically, it is used in conjunction with other philosophies, mostly to time trades, rather than as the sole rationale for decisions.

Others use quantitative analysis aiming to identify market trends, arbitrage opportunities or mispriced securities relative to valuation models. These managers do not meet companies’ management. They use computer programs, algorithms and technology to analyse data (increasingly big data) to generate trades.

If a quant model works, it is marvellous. However, one weakness is that quant models rely on historical patterns. They may fail to forecast changes in behaviours or inflection points.

Some managers believe in top-down asset or sector allocation, whilst others believe in bottom-up security selection. Some focus on the short term, frequently changing their portfolios, whilst others adhere to long-term buy-and-hold. Some believe in value, whilst others believe in growth or momentum. Some believe in cost-cutting passive management, whilst others believe in active management.

There is no right or wrong philosophy. The question is whether the manager can consistently add value by using it.

What is your philosophy?

Process

Process is the framework and steps of managing the fund. A good process helps delivering repeatable and predictable results. Normally, process goes through the following broad stages:

1. Establishing investment objectives.
2. Setting a philosophy and an investment strategy to achieve the objectives.
3. Implementing the strategy by selecting investments and constructing a portfolio.
4. Ongoing monitoring of risk and performance.

Not being a full-time manager selector, you will not meet managers, questioning their philosophy and process. The process’ highlights may be available in the fund’s marketing materials (fact sheet, brochures). However, it would be difficult for you to scrutinise it.

Portfolio

Portfolio is the fund’s characteristics.

The fund’s holdings should match the manager’s philosophy and process. Most funds publish at least their top 10 holdings. Assess whether the fund holds what it is supposed to.

Consider fund size. Small funds with AUM below £100 million might be too small and doubtful as a viable, ongoing business. Huge funds with AUM above a number of billions may run into capacity issues. The fund should be not too small and not too big.

Portfolio also covers product characteristics, such as investment vehicle, fees and costs. These topics will be covered in depth in the next chapter.

Performance

Whilst you should not base your selection solely on performance, it is essential. You want managers who demonstrated they could add value.

Bad recent performance of a manager with a long good track record may be a buying opportunity. Perhaps going through a bad patch, the manager can recover.

Try to understand the reasons for performance and whether it matches the philosophy and process. Professional manager selectors comprehensively analyse performance. They have tools to break it down to its drivers, checking whether it is in line with the manager’s style.

For example, performance can be due to continuous excess risk taking, enhancing performance as long as markets perform well (fair-weather investing). This is not skill. It is luck that will run out when markets turn around.

If performance of a manager who claims to be a bottom-up security selector is explained by top-down sector rotation, for instance, then it does not match the manager’s claims. It is not enough that performance is good or bad. How it was generated is critical.

De-selection

De-selection is the process of selling funds you own.

Fund due diligence is not only an initial step, but also it is ongoing. After selecting a fund, monitor its performance and other factors, ensuring it delivers and no material changes warrant a review. The time may come to deselect or switch funds.

Observe fund performance. However, do not be trigger happy, switching funds lightly. It may involve costs (transaction costs, switching costs) as well as time and effort choosing new funds.

A disappointing performance over a couple of months should not be a sole reason to switch a fund, unless it is an abrupt, severe underperformance without an explanation. Performance should be evaluated over the medium term (1–5 years). If it is consistently bad, consider switching.

Material changes, such as a manager leaving, might be an argument to contemplate de-selection. Use judgement and common sense to ascertain if the changes compromise your conviction in the fund’s ability to perform in the future.

Monitor market conditions, ensuring they still support your fund selection. For example, if you chose a defensive fund since your market view was negative, you may want to switch to an aggressive fund if market dynamics improve.

If in serious doubt about a fund, sell it. Do not let behavioural biases, such as affinity to funds you own, deter you from selling for good reasons. They are not your funds. You hold them to make money – have no emotional attachment.

Summary

• Funds have several advantages over individual securities. Unless you are willing to make the effort and skilful in selecting securities, use funds. Funds charge fees, but you gain diversification, lower transaction costs and professional fund management.
• Active funds can add alpha. However, they are more expensive than trackers and they come with manager risk. Consider active if you commit to select and monitor and possess selection skills. Trackers are cheaper than active and manager risk is low. However, they do not add alpha.
• The investment spectrum includes funds ranging from passive, through enhanced indexing and smart beta, to active. Use funds from across the spectrum.
• Past performance is important but it is in the past and may not repeat in the future. The key is selecting funds that are likely to perform going forward. Qualitatively assess funds and managers, following the 6P due diligence process – platform, people, philosophy, process, portfolio and performance.
• Deselecting funds should be based on long bad performance and/or by qualitative rationale, such as a fund manager leaving the firm.

Notes

¹ 4% = £20 ÷ £500.

² If the minimum dealing charge still applies, consider accumulating larger sums before investing to reduce the number of transactions.

³ Portfolio turnover is calculated by dividing the lesser of values of purchases and sales by the fund’s net asset value (NAV), typically over one year. The ratio loosely indicates the percentage of the portfolio’s holdings that have been changed. Portfolio turnover can generate taxes. Stamp duty can be charged when buying securities and CGT can be charged when selling securities at a profit.

⁴ A number of academics claim that, on average, active managers underperform. See Burton Malkiel (1973), Charles Ellis (1975) and William Sharpe (1991).

⁵ Cross sectional volatility measures the variation or dispersion across returns of securities at one specific time. Standard deviation, on the other hand, measures volatility of returns over time. σ_CS = ✓[Σ(r_i − r_m)² ÷ n] where r_i is return of all n assets i at time t and r_m is average market return at time t.

⁶ The Fundamental Law of Active Management was developed by Richard Grinold. IR = IC✓BR; where IR is information ratio, IC is information coefficient and ✓BR is square root of breadth.

⁷ Counterparty risk is the risk of each party to a contract that the other party – the counterparty – will breach the contract. Swaps are over-the-counter (OTC) derivatives, which are contracts between parties. Counterparty risk is similar to default risk.

⁸ Securities lending involves loaning securities to other investors or firms for a fee. The borrower posts collateral with the lender to reduce the risk of not returning the securities and paying the fee. Securities lending is important for short selling.

⁹ 25% = £10 million ÷ (£10 million + £30 million); 75% = £30 million ÷ (£10 million + £30 million). A price-weighted index will have 40% in stock A and 60% in stock B. An equally weighted index will have 50% in stock A and 50% in stock B.

¹⁰ The top sector weights in the FTSE 100 Index are banks 14%, oil & gas 14%, personal & household goods 11%, healthcare 9%, basic resources 7%, insurance 7% and industrial goods & services 6%.

¹¹ The definitions of smart beta vary. Some define smart beta as a weighting scheme different from market-cap. They exclude exposure to rewarded risks from smart beta. Systematic exposure to rewarded risks often is called alternative beta or risk premia.

¹² The tendency of low-beta stocks to outperform is an anomaly since, according to finance theory, high-beta stocks should outperform.

¹³ Enhanced indexing and smart beta strategies are called hybrids since they mix the characteristics of passive index trackers and active funds.

¹⁴ Cash + 3% = 60% (Cash + 5%) + 40% (Cash).

¹⁵ Some workplace pension schemes use lifestyle funds or a mix of DGFs and TDFs as the default choice – you might be invested in one without knowing it.

¹⁶ Morningstar’s star rating assigns one to five stars to funds. It measures how well a fund has balanced risk and reward relative to its peers. Keep in mind that fund star ratings are strictly returns-based and do not take into account fund fundamentals, such as manager changes.

¹⁷ Morningstar’s analyst rating assigns gold, silver, bronze, neutral and negative rating to funds. It is a qualitative, independent view on funds, considering five key areas for each fund: People, Parent, Process, Price and Performance.