How to pick funds
The simple way to sort through thousands of products to create your perfect portfolio
Saving money either as a lump sum or on a regular basis is an excellent first step towards having a healthy and wealthy time in later life. The second step is choosing where to put your money.
This task isn’t always straightforward as there are more than 2,000 individual companies on the London Stock Exchange and more than 3,000 unit trust and Oeic (open-ended investment company) funds available to UK investors alone.
Add in hundreds, if not thousands, of investment trusts and exchange-traded funds and you’re drowning in investment options.
To help you navigate this busy landscape, we will now explain how to pick actively-managed funds, focusing purely on unit trusts and Oeics.
You will learn how to filter the wide range of funds and find the products that match your investment requirements.
Our guide will explain which details are most important when reading fund documents and the vital bits of information which many investors neglect to obtain when researching products.
STEP 1: INVESTMENT GOAL AND TIME HORIZON
Picking funds is easier than you might think. It requires a systematic approach and a short amount of time for in-depth research once you’ve built a short list of products that meet your needs.
You should always start by writing down your investment goal and time horizon for achieving that goal; i.e. why you want to invest, how much you want to make and when you will need to access that money.
For example, let’s say you are a 40 year old who wants to build up an investment portfolio that will pay for your child’s university education in 10 years’ time; you might alternatively be a 50 year old who wants to have a decent sized ISA in 15 years’ time to bolster a workplace pension.
You then need to establish your appetite for risk. For example, it’s no good buying a fund with high risk assets like biotech firms or miners if you have to rely on that money in five years’ time to pay certain bills. Those types of businesses can generate high returns – but they can also experience large losses if drug trials fail or commodity prices are weak, for example.
In contrast, buying a very low risk fund may not be appropriate if you need to make 12%+ annual returns in order to hit your investment goal. You need to find a balance between taking on enough risk to generate the desired returns and not being too bold so as to risk losing a large chunk of your money.
Importantly, you may need to rethink your time horizon if your financial goal requires you to take excessive risks. It is better to be invested for a bit longer than to go all guns blazing with high-risk investments and hope nothing goes wrong.
STEP 2: INCOME OR GROWTH OR BOTH?
Investors fall into different camps. Some want to generate a regular income from their investments, particularly people in retirement. Others don’t need income at present and simply want to grow the value of their investments over time. And there are people who want a bit of both.
It is fairly easy to see which funds offer income, growth or both as they will either have the styles in their product title or it will be clearly explained on their website. One way to filter the pack is to use an online screening system such as the one offered by financial data specialist Morningstar. For example, it powers the fund screening system on AJ Bell Youinvest’s website where you can you search by geographic focus such as funds that invest in Asian companies; as well as filtering by category such as bond fund, property fund or US small cap equities. To find funds that pay a regular income via Youinvest’s fund screener, click the ‘Inc’ box on ‘Distribution Status’ and that will instantly knock out funds that either don’t pay a dividend or coupon, or ones that essentially roll up any payouts back into your fund holding. You can then narrow the search by using the variety of drop down menus including the name of the company running the fund such as Baillie Gifford or Jupiter.
IT’S NO GOOD BUYING A FUND WITH HIGH RISK ASSETS IF YOU HAVE TO R ELY ON THAT MONEY IN FIVE YEARS’ TIME TO PAY CERTAIN BILLS SOME WANT TO GENERATE A REGULAR INCOME FROM THEIR INVESTMENTS, PARTICULARLY PEOPLE IN RETIREMENT. OTHERS DON’T NEED INCOME AT PRESENT AND SIMPLY WANT TO GROW THE VALUE OF THEIR INVESTMENTS OVER TIME
STEP 3: DON’T LIMIT YOURSELF TO ONLY BUYING FUNDS THAT HAVE DONE WELL IN THE PAST
There will be a temptation at this point to pick the funds which have the best past performance data. Many people assume a fund that has done well in the past will continue to thrive in the future. They may also ignore funds that haven’t done well, presuming they are inferior products.
Don’t make this mistake. You need to understand the bigger picture, namely how the broader markets were performing and whether a fund should have unperformed or outperformed due to the style of their investment strategy either being out of, or in, favour. More on that point later.
LOOK AT ANNUAL DATA
We like to look at discrete annual performance data over at least five years; a 10 year period is even better. That will show you if a fund has been fairly consistent with its returns or whether it simply had one or two good years over a decade which made its headline data (also known as cumulative data) look attractive.
For example, let’s say a fund has gone up 80% over 10 years. It may have seen eight years with negative or flat performance but had two amazing years (perhaps because the overall market was soaring) with which to achieve that large overall performance when looking at a 10 year view.
‘It is very easy to be lucky over a short period of time,’ says Ryan Hughes, head of fund selection at AJ Bell. ‘You see a lot of fund managers that exhibit exactly that characteristic.
‘They have a very strong period of performance over a very short period of time. The skill of someone researching and choosing a fund is to determine whether that performance was genuine skill or simply just good fortune,’ he adds.
‘I would equate that to going to the casino. You might have a one-off visit and make a profit. That is very lucky. If you go to the casino week after week, I would imagine over time the casino would win – so there is no evidence of skill in that approach. Over the longer term skill is separated from luck. It is genuinely difficult to be lucky over a long period.’
LOOK AT WHAT’S DOING WELL AND WHAT ISN’T
It is important to recognise that not all managers who are performing poorly are doing a bad job. It may well be that their investment style is out of favour.
They might be value investors who only buy stocks when they are really cheap in the belief that the market has priced them incorrectly. They may struggle when the market is chasing growth stocks, even ones that are trading on high valuations.
The fund will stand a chance of having a stronger period of performance when its style comes back into favour.
For example, JOHCM UK Opportunities Fund
(GB00B95HP811) is very strict on valuation and will sell a holding when its valuation looks excessive. You may have heard the phrase ‘run your winners’, referring to investors holding on to their best performing stocks in the hope that an upwards share price trend will remain intact. For JOHCM, it doesn’t think twice about selling its winners when they look overvalued.
It has underperformed the FTSE All-Share benchmark on a one, three and 12 month basis, so too on a five year basis. That’s because its value-led approach is not in kilter with current market trends. Indeed, one fifth of its portfolio is in cash, waiting for opportunities to emerge should valuations start to fall across the market. On a longer term basis, the fund has outperformed the index four out of seven years up to the end of 2016
IT IS IMPORTANT TO RECOGNISE THAT NOT ALL MANAGERS WHO ARE PERFORMING POORLY ARE DOING A BAD JOB. IT MAY WELL BE THAT THEIR INVESTMENT STYLE IS OUT OF FAVOUR.