How to think about fund investing

Nikki Matthews

Senior Consultant

The bottom line:

Understanding the characteristics of funds and how they behave in different environments is important in deciding when to allocate and redeem. Thinking about the fund’s key purpose in your portfolio (a return driver, or diversifier for instance) and evaluating whether it is achieving this can help optimise investment decisions.

It is frequently cited that asset allocation drives 90% of investment returns - this is only partially true. This study explains that 90% of any one investor’s returns over time will indeed be determined by the assets they chose to allocate to. However, only around 40% of the difference in performance between other investors’ portfolios is determined by asset allocation. So, what explains the rest? Asset-class timing, style within asset classes, security selection, fees, and manager selection. So how can investors ensure they get the 60% right? This article outlines some ideas for how to think about fund investing. A lot of this boils down to establishing enough conviction to hold onto an investment approach through inevitable underperformance and resist the damaging urge to churn portfolios.

Understand the fund’s objective and the environments that it may outperform or underperform in

This is beneficial in understanding whether the fund is behaving as expected. Underperformance is quickly picked up on by investors. However, unusually strong outperformance is also a red flag, often mistakenly seen as green as investors are naturally less concerned when their portfolio is generating positive returns. Netflix recently released a documentary on Madoff (a good watch) - for those not familiar, Madoff’s funds had never endured losses. What was fascinating in this case was that the returns could not be explained by anyone, and yet the world's largest Ponzi scheme operated for over 20 years, only unravelling thanks to the 2008 financial crisis.

Moving away from extreme cases, understanding how the fund you are investing in generates returns and how it is expected to perform under various market environments helps with monitoring it for outliers, either positive or negative. The danger is any underperformance is treated as something being wrong, whereas it is an inevitable consequence of an investment posture.

Once a fund is selected, a framework could be created with expected lower and upper performance bounds, and a set of pre-determined actions to follow in the instance these are breached. This would help temper the emotion involved in decision making. Investors tend to overemphasise losses and so if a fund is underperforming it could lead to selling at the worst possible time (before it rebounds) and crystallising losses. Trying to constantly choose the best performing fund can lead to the worst outcome. It is more important to determine whether the underperformance is in line with the fund’s process and evaluate whether you believe it can still generate returns going forwards. If it is outside its expected range, it is likely the manager should be replaced.

Understand why you are holding the fund

For instance, is its main purpose a diversifier or a return generator and how does it interact with your other holdings? If there is overlap in certain funds you hold, your overall portfolio may be overly concentrated. Funds’ allocations naturally change over time, so it is important to monitor the correlation of your holdings on an ongoing basis for adequate diversification, which is especially beneficial in times of market crisis.

Active or passive?

Deciding to invest passively is an active choice as it automatically over and underweights certain sectors, depending on the index. Consider whether the index composition is offering you access to the markets you would like to invest in and monitor it to ensure it is still giving you the desired exposure over time. If choosing to invest actively, determine whether the manager is providing you with the desired exposure. If the investment universe changes over time, assess whether this is exposure that is beneficial for your circumstances.

This can be positive for certain types of funds, eg multi asset where an allocation to ‘new’ assets can help diversify further and generate additional returns. However, it is important to ensure the manager has the skill set to allocate to these assets. If an equity manager’s expertise has always been large cap and they are suddenly allocating to small cap (‘style drift’), this is likely a red flag.

Understanding the market environment you are investing in is also important as to deciding whether to invest actively or passively and in portfolio construction. For the last decade or so, investing passively in equities and bonds would have generated strong returns as the correlation between the two asset classes was negative. However, recently correlation turned positive and there is increased dispersion and volatility within markets, therefore active investing, and the ability to be nimble is well suited to this market environment.

Assets under management size is an important consideration

Investing in a fund that has significantly increased its assets under management (AuM) could mean the opportunity set has changed and it is not possible to invest in the same areas as when the fund was smaller. The fund’s ability to generate value may be compromised, leading to lower expected returns going forwards. Depending on the fund’s investment universe, capacity should be limited accordingly to ensure its competitive advantage can potentially continue.

Get the right breadth of risk measures

Understanding the characteristics of the asset class and examining whether volatility has remained within reasonable bounds is sensible. However, using only volatility as a measure of risk can be misleading, as it only focuses on price.

Illiquid funds are valued less frequently and therefore their volatility is understated – not because the asset class is inherently less risky but because the volatility in returns is simply not observed. Investors do not have the option of withdrawing their assets at any time and finding an alternative. If performance fluctuations (within expected ranges) were ignored with regards to investors’ liquid holdings, higher longer-term returns may be achieved, through less fund turnover, and less locking in losses. This may also mean the illiquidity premium could be overstated; perhaps similar returns could be achieved in liquid markets by looking the other way when they misbehave.

So, what other risk measures can investors look at for a well-rounded picture? 'Beta', or correlation to the underlying market, and the fund benchmark, tracking error (if the fund is index tracking) and for bond holdings, credit quality is a useful risk measure.

Conclusion

To summarise, deciding where to invest your assets once you have decided your asset allocation can be a key driver of your investment outcomes. Interested in learning more? Please contact me to understand more about decision making and fund selection. Joe Wiggins's book ‘The Intelligent Fund Investor’ also explores several of these ideas in greater depth.