The challenges of fund selection

One of the biggest investment challenges is to identify funds that will consistently outperform. David Coombs explains that some of the ‘golden rules’ of fund selection may instead lead to missed opportunities and lower returns.

With so many investment funds to choose from, how can you identify the likely winners for your clients? As a starting point, many firms apply ‘golden rules’ to screen out less attractive prospects. The appeal of such a process is clear, but it pays to understand what each rule is aiming to achieve – applying them slavishly is likely to narrow your options excessively, potentially reducing returns.

#1 Star managers are less risky

This ‘golden rule’ seems unarguable at first glance – how can it be wrong to focus on high-profile managers at respected companies? It isn’t wrong per se, but it is crucial to understand how they became a star i.e. how they generated alpha and outperformed their peers. If it was by investing in obscure or illiquid assets, their approach may not work when scaled up to a star manager-sized fund.

Likewise, an active trading strategy may be less successful if the manager is distracted by the marketing demands that go with large funds. Or, it may be that a manager’s reputation was earned in different market conditions – few managers are equally good in both bull and bear markets. These are all examples of involuntary style drift. Whether a conscious choice driven by arrogance (“I’m simply a better fund manager whatever I buy…”) or unwittingly forced by a greedy marketing team that won’t close a fund, such drift is often fatal for performance.

#2 A three-year track record is crucial

Most firms apply a blanket quant screen which requires a manager to have three years of performance data. A sensible ‘rule of thumb’ maybe, but not a golden rule. I’m not recommending backing unknown managers with no record, but why rule out managers starting new funds whose prior career, investment expertise and strategy point to success?

You may forego three years of outperformance at the point where the fund is small enough for the manager to be nimble and generate real alpha. New funds are often incubated, so the manager can really focus on investing, free from marketing pressures – you may even get a fee deal for your support!

#3 Buy first quartile/sell fourth quartile funds

Assuming outperformance isn’t random, why not ‘stick with the winners’? Surely, an investment approach that worked last year will work again this year. Again, this rule is initially appealing, but what evidence is there that the strategy can be maintained? After all, the FCA warns unwary investors that past performance is not a guide to future returns.

The key is to understand why the fund is first/fourth quartile and to analyse the current portfolio to see if it is likely to out-or underperform again. If a fund has outperformed and is first quartile, it could be at a significant valuation premium to alternatives. Now may not be a good time to buy that particular fund. Put another way, this rule could be seen as ‘buy high, sell low’ – hardly a recipe for good returns.

Looking at valuations may help, but won’t give the whole picture as they are only meaningful in the context of a manager’s investment strategy. A premium valuation may be OK if the manager is a committed growth investor and has already repositioned his portfolio to take advantage of future opportunities.

#4 Pay the lowest fees possible

No one wants to pay higher fees than necessary and some hedge fund fees are still egregiously high. However, an obsession with low fees can be counter-productive. As with everything, there is a ‘fair price’ for good investment. If a fund sells itself too cheaply, its commercial proposition will be affected – the only way to make a fair return would then be to sell more units, shifting the emphasis from investment performance to asset-gathering. As already described, this can badly undermine a manger’s performance.

Conclusion

None of these golden rules are wrong as such, but they can lead to false conclusions. The key is to apply them sparingly and instead develop a deeper understanding of what is going on in the funds. Such insight requires time and expertise – at Rathbones, our research team meets hundreds of managers a year to understand what is going on behind the data. Although it’s still difficult to identify the winners, we’ve had notable successes by overriding the ‘golden rules’.

This article appeared in the March edition of The Trade Press, the monthly magazine of the Federation of European Independent Financial Advisers (FEIFA).

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