How to invest in active funds

Smart Investor magazine, August 2008

Managed funds do the hard work for you. You hand over your cash, and then a portfolio manager, sometimes supported by a team of other researchers, sifts through the markets to work out the best opportunities on your behalf. You sit back and, all being well, watch the money roll in.

That’s the theory, anyway. It’s certainly true that for all but the savviest investor, you stand a better chance of success going through a fund manager than going in yourself. Fundies have the greatest range of research, from data feeds to analyst opinions, to guide their choices; often they have spent time with the management of the companies themselves, kicking the tyres and working out just how the company fits together and what its prospects are. You and I generally don’t have the time or the access to do that.

But the choice of managed funds in Australia is bewildering. There are 10,889 investment options in the database of fund researcher Morningstar (though many of these do overlap with each other, such as the same product being sold in an investment trust and a superannuation form, or through a number of different platforms). How does one pick the best?

It’s particularly challenging with active funds – those that make stock selections and try to beat the market, as opposed to passive or index funds, which simply try to replicate the performance of the market.

The first thing to do is to work out how the funds are going to fit in with the rest of your portfolio. If you already hold a lot of Australian shares, for example, you might want to give a bit less weight towards an Australian equity fund than you otherwise would.

Also, it’s becoming increasingly common for investors to use an index fund to get the performance of the market, and then invest in some very active managers alongside them. What do we mean by ‘very active’? Well, some funds are known as benchmark-huggers – they will try to beat the market, but are required to stay very close to its overall allocations. So, for example, they might be allowed to deviate by a few percentage points from the index weight in, say, BHP Billiton or Telstra, but not bet the house on it, nor to ditch it completely.

The benefit of this benchmark-aware approach is that you’re never going to be too surprised – in either direction. A fund like this is never going to underperform the market too badly, nor is it going to beat it out of sight either. But some people feel that there’s no point in paying active fees for a fund that behaves a lot like a much cheaper index fund, so there is growing interest in funds which have no constraints at all to track a benchmark, and can just put their money where they want to.

So how do you work out how a fund operates? Where do you start? Many publications like Smart Investor and the Australian Financial Review newspaper regularly contain performance data on a wide range of managed funds, so that gives you a sense of some of the managers, products and their recent numbers. Both these publications have helpful occasional features that go into much more detail about fund managers, and in some cases give rankings in particular asset classes; look out for Smart Investor’s Blue Ribbon Awards, or the AFR’s Managed Funds Quarterly. You can also use research from sites like Morningstar to work out who the better performers are in a given asset class.

Be aware, though, that chasing last year’s performance is often a fool’s game. It is very rare that a fund that leads the league tables one year repeats the feat in the next. That doesn’t mean you should go looking for the ones that have crashed – some funds start poor and stay poor – but it does mean you shouldn’t set too much store in recent performance. What you want is good long-term returns, and ideally you should be looking at about a five year track record.

If you’ve found some funds you want to know more about, look up the manager’s web site and look for the product disclosure statement, or PDS. This gives more details about the fund’s investment style, where it allocates, whether it can put money in cash if it thinks it appropriate to do so, what benchmark it measures itself against, and fees.

Fees are something all potential investors want to look closely at, and rightly so, since they can really eat into returns in the long run. But it is better to pay for quality management than to save money on the fee and lose money on the investment. In a market as competitive as Australia, fees don’t vary that much between products in mainstream areas like Australian equities, but you are beginning to see the arrival of something called a performance fee in some products.

A performance fee normally works like this. There is a modest regular fee that is charged regardless, and this is usually lower than the management fee that mainstream funds charge. But on top of that, if the fund beats a particular hurdle (often just its benchmark index, or that index plus a few per cent), the manager can charge a performance fee, often as much as 15% of the excess returns.

Some investors blanch at those numbers; others see it as a much more appropriate sharing of risk and reward between the investor and the manager, ensuring that they both have the same interests at heart. If you are looking at a fund with a performance fee, check that it uses a high water mark structure – that means that if the fund starts going backwards, it has to recover those losses before it can start charging a performance fee afresh.

Performance fees are particularly common in absolute return or hedge funds. These terms cover a multitude of different styles of investment, but often they can short sell – that is, make money out of a stock that is going down in value, rather than up. You may want to give this style of investment a try, especially in a market like this, but remember that very few managers truly boast the skills and experience to get it right.

Many funds have an up-front fee you pay before your money starts going to work for you, but this isn’t generally set by the fund manager, but by the financial planner who puts you into the fund. That’s a battle you have to negotiate with them. If you’re using an investment platform, that too is likely to have an entry fee. Something else to look for is the buy/sell spread, another fee, usually modest, lodged when you go into or out of a fund. Any PDS should set out all the potential fees in detail.

In Australia, you can buy managed funds covering a whole host of asset classes. You can get into foreign property, Chinese shares, all sorts of weird and wonderful structured debt, even agricultural investments. A very important decision you need to make is how this will all fit together: how much money do you want in overseas assets? How much in shares, or property, or bonds? You might want a financial planner to help you with this.

When you invest in overseas funds, another decision to make concerns hedging. If you buy a fund that holds lots of US shares, and those shares go up in value by 10%, but the US dollar declines against the Aussie dollar by 10%, then you haven’t made a thing, because the currency movement wiped it out. Alternatively, if the currency moved the other way, you would have made 20% instead. Some people prefer not to live with this uncertainty, and that’s why you can often buy hedged international equity funds, which take the currency out of the picture.

Some of the more out-there asset classes sound great at the time, as if you’re getting in on a secret nobody else has heard. You can, for example, invest in funds that hold only Chinese equities, or Indian equities (both of which, incidentally, have tanked in the last six months). These funds are fine provided you accept that they are not going to be diversified, so they need to fit into your portfolio accordingly.

A good fund isn’t just one with good recent numbers and reasonable fees. There are several other things you’ll want to consider, if you can find them out: how experienced is the investment team, and have any of them departed recently? What sort of risk does it take to generate its returns? (For example, a small cap fund usually takes more risk than a large cap fund.) Does the fund use leverage – which is great when things are going well, but bad news if they’re not? Is there a lot of turnover in the fund – that can have an impact on your tax. To get into this sort of detail, though, you’re really going to have to go to one of the research houses such as Morningstar, van Eyk or Standard & Poor’s. Research houses have different models but many of them charge a subscription fee for research on managed funds and other products.

And, once you’re in, stay in. If you’ve put all of this effort into selecting a fund, you don’t want to bail out after it has a miserable first six months. Good managers perform well over the long term, and just because they might be beaten by a particular style of investment over shorter periods doesn’t mean you should abandon ship – a bad move for tax reasons, fees, and simply because it goes against the wisdom of spending time in the market with a well thought-out strategy. Good luck.

TEN TIPS

• Know how a fund is going to fit into your overall portfolio
• Short term returns tell you nothing – look for returns over at least three years and ideally longer
• Study the fees. If there’s a performance fee, does it have a high water mark?
• Try to understand how much risk the fund takes to make its returns.
• Does the fund have to stay very close to its benchmark? If so, would you be better off with an index fund?
• Very specific funds like China or agribusiness can do well, but are not diversified, and should fit into your portfolio accordingly
• The higher the turnover in the fund, the bigger the tax impact
• Long/short funds give managers greater freedom, but you need to be confident they can use that freedom effectively
• Watch out for recent key staff departures at fund managers
• Try not to get too much overlap in your funds