Simple Pound

Yesterday’s FT had an interesting article about a new investment fund that pre-selects its companies based on the male-female ratio in key management positions. Their reasoning is based on studies that have shown greater stock price resilience in weak markets for companies with a higher proportion of women in roles of responsibility. The fund is trying to exploit the basic premise that such firms tend to outperform over time.

A closer look, however, shows that the fund has underperformed its benchmark index since it launched in April 2006. While the MSCI Total Return (Euro) gained around 21% in that time, the Amazone Euro Fund only achieved 17%. Bearing in mind that it is an actively managed fund and hence comes with an annual management fee of 1.5%, the overall performance is even lower.

On the other hand, the fund has a long-term focus with an investment horizon of at least 5 years, which suggests its prime time might be yet to come. The 30 odd companies which are currently held in the portfolio achieved a mean operating margin of 11 per cent coupled with a mean return on equity of 19 per cent - all of which are more than stable figures and might boost performance during bearish market times.

I’m still a little on the fence with my opinion about the fund. On the one hand, it clearly underperforms its benchmark. But on the other hand, it seems a defensive investment strategy for times where the majority of funds head south. Its low turnover and volatility could potentially make it a stable investment in the long-run, but this remains to be proven. In the meantime, I will keep watching its performance while also having a closer look at its major holdings. These include for instance L’Oreal, Essilor, Hermes, Swatch, Statoil, PepsiCo or Pearsons – many of which have exhibited stable growth over the years.

Bookmark It

Hide Sites

The last two posts in this series were rather theoretical so I decided to give it a more practical twist by actually comparing two funds with each other to decide which seems the better choice.

I decided to take two UK Large-Cap equity funds. The first is the Fidelity MoneyBuilder UK Index Fund and I will compare it to the Legal & General Growth Trust. Both funds are selected more or less randomly (Fidelity and L&G were the first fund managers that came to mind).

Morningstar Category.
So, let’s get started. The first thing to check in order to guarantee a well-balanced and diversified portfolio is the Morningstar Category. This is UK Large-Cap Blend Equity in both cases, so we know that whichever fund we’ll pick our portfolio have some exposure to the UK market and more specifically UK companies with a large market capitalisation. This provides a good foundation because large-cap companies are generally established companies that provide stable and reasonably reliable returns.

Returns.
Next, we’ll have a closer look at the fund’s returns in the past 3 years. To do this, we need to have go to the fund’s subsection “Risk & Rating” (Fidelity, L&G). Fidelity’s mean return based on the last 3 years stands at 19.42%, which means that on average your money increased in value by 19.42% per year. Legal & General on the other hand offers an average return of 27.27% per year. If you want to get a better idea about the actual returns per year in the recent past, the subsection “Total Returns” will provide you with exactly that (Fidelity, L&G). Here we can see that Fidelity achieved a growth of 16.50% in 2006 and a growth of 8.49% in the first 5 months of 2007. Compared to L&G who grew by 29.53% in 2006 and 15.52% in 2007 so far, Fidelity clearly loses out. Overall, Legal & General’s fund is in a better position in terms of returns.

Volatility.
The investor who is looking for long-term returns should be willing to sacrifice some returns for lower volatility as this will generate higher capital growth in the long run. Therefore we look at volatility next. To do this, we need to return to the Risk & Rating section. Fidelity’s mean volatility for the last 3 years equals 7.61% which means that most of the time (in 66% of the cases should you really want to know) the fund’s returns were somewhere between 11.81% and 27.03% (19.42% +/- 7.61%). Legal & General on the other hand had a standard deviation of 10.02% leaving the returns somewhere in the range of 17.25% and 37.29%.

This is the first time the comparison gets a little tricky, because you have to decide for yourself whether you want to stomach the extra risk the L&G fund brings in return for higher growth. L&G’s volatility is 30% higher than the Fidelity fund, but their returns exceed Fidelity’s on average by 40%. Therefore I think L&G seems to be the better fund (if only slightly) in this category as well.

Costs.
The next criteria to look at concerns the fund’s management fees and thus the costs that will bring your net return down. From the return & volatility analysis above I would suspect the L&G fund to be more expensive, but let’s have a look. Head over to the “Fees” section at Morningstar to get an overview of their fees (Fidelity, L&G). The good news is that neither of the funds has an initial charge, which means that the full amount of your investment will work for you (as opposed to, e.g. 95% for you, 5% for the fund managers). Fidelity’s fund is an index tracker fund (as the title suggests) and therefore the management fees are extraordinarily low at 0.10%. Therefore you got an average net return of 19.32% in the last 3 years with Fidelity.

Legal & General’s fund is actively managed and hence has higher management fees of 1.50%. Based on my experience, this is about average for actively-managed funds but you have to know for yourself whether or not you are willing to pay 1.50% of your investment for 40% higher returns (in this case). Theoretically, your net return with the L&G fund would have been 25.77% on average in the last 3 years. In practice, however, you will have to pay an exit charge of 5% when you sell this fund which will obviously diminish your returns. Therefore, I’d say that Fidelity’s fund clearly wins the race in terms of associated costs.

Risk.
Having already considered the volatility of the two funds, let’s return to the subsection Risk & Rating to compare the fund’s risk to the overall category. The results aren’t really surprising and show that Fidelity has a just average risk exposure compared to all the UK Large-Cap Blend Equity funds, while L&G’s risk is higher than many other funds. Again, you will have to decide for yourself whether or not you want to have this extra risk in your portfolio and whether the extra return the fund gained in the last 3 years is sufficient to balance the additional risk.

Bear in mind that the stock market doesn’t always go up though and that you will have to re-balance your portfolio once a year no matter how the individual assets performed in order to make best use of the asset allocation principles. Thus, I think that Fidelity is the better choice for long-term, risk-averse investors while L&G has its place in more aggressive portfolios.

Fund objectives.
Back to the overview page to find out more about the funds’ investment objectives. We already worked out that the Fidelity fund is an index tracker fund, therefore it is not surprising to find the following objectives:

The fund aims to achieve long-term capital growth by matching the performance of the FTSE All Share Index as closely as possible, with the minimum of tracking error.

L&G on the other hand has the following objectives:

The investment objective is to secure capital growth by investing in a portfolio principally of UK shares. Securities of companies with strong growth prospects will be chosen.

This shows that the Morningstar category doesn’t necessarily reflect the L&G fund accurately as I would have put it into the Growth category instead. While the growth fund seems attractive and potentially more lucrative than an index fund, market efficiency shows that growth stocks won’t grow indefinitely and that value stocks actually outperform the market in the long run.

Any diversified portfolio should have exposure to both categories to ensure both stability and as well as a decent growth and hence capital appreciation, but with objectives like this I would not choose the L&G fund as a portfolio base but rather as an addition to get some more exposure to growth funds. I’m quite pleased that I could demonstrate how important the funds’ objectives are when deciding whether or not a particular fund is right for you.

Morningstar Style Box.
The last but one criteria to consider is the Morningstar Style Box, which can be found on the fund’s overview page. With a category name like “Large-Cap Blend Equity” I would expect to find both funds with a style box combination of “Large” and “Blend”. However, Fidelity deviates from this with a style defined as Large-Value. L&G on the other hand, which I would have associated with Growth, has a Large-Blend style in line with the category.

To be honest, I find this a little confusing because I would prefer a “Large-Blend” fund as a portfolio base but at the same time I am convinced that the L&G fund is unsuitable for this. Hence to gain more clarity, this would be the point at which I would switch to the “Portfolio” section (Fidelity, L&G) to have a closer look at the fund’s asset allocation.

Morningstar Rating.
And finally, the Morningstar rating tells us that Morningstar deems the L&G fund (5 stars - top 10%) to be better than the Fidelity fund (4 stars - top 32.5%). Here the word “better” is somewhat controversial as it clearly depends on the purpose we think the fund should have.

As I have implied earlier, the overall conclusion I would take away from a comparison like this, is to use the Fidelity tracker fund as a solid base for the portfolio which can then be enhanced by additions like the L&G which will provide the portfolio with more aggressive growth exposure. In fact, by looking at the Portfolio section of the L&G fund it becomes obvious that a high percentage of the fund is invested in mid-cap stocks, which are inherently riskier and more volatile. This proves my “gut feeling” of not relying on the L&G fund to provide steady and reliable returns.

I hope you found this comparison useful despite the lengthy nature of the post. If there are any more questions with regards to Morningstar and/or fund comparison, please get in touch either by leaving a comment or by contacting me directly!

Bookmark It

Hide Sites

After I shared half of my wisdom about fund selection, I’ll continue today with the remaining features to look out for when deciding which fund(s) to include in your portfolio.

I discussed the Morningstar category, returns, volatility and costs yesterday.

Risk. Based on the category your fund belongs to, Morningstar makes a relative comparison for returns and risk. For example, this fund had consistently high returns (relative to the UK Large-Cap Blend Equity category) but is exposed to a higher than average risk as well. This essentially means that you could get the same category exposure at lower risk. Ideally one would find a fund that has higher than average returns for the category while maintaining average risk. (This information can be found in the subsection “Risk and Rating”)

Investment objectives. Every fund manager has some high-level objectives that (s)he tries to achieve with her security selection. Look out for buzzwords like growth, risk or income to get an idea whether the fund is more conservative or aggressive. I suggest you diversify across different objectives as well to be sure to include some defensive funds that will achieve moderate returns no matter what. (This information can be found on the fund overview page)

Morningstar Style Box. This mainly applies to equity funds and illustrates the area of concentration in terms of large-cap, mid-cap or small-cap as well as value, blend or growth where blend effectively describes an even mix between value and growth (refer back to my shares introduction if you don’t know what I’m talking about). Your portfolio should contain at least one representative for every “box” to make sure you have diversified well enough across different capitalisation sizes and equity types. The fund that I used as an example earlier has the following style box:

and has therefore a nearly even mix between large-cap growth and large-cap value stocks. (This information can be found in the subsection “Portfolio”)

Morningstar Rating. This rating is probably one of the more important numbers you should consider, and personally I would not invest in a fund that doesn’t achieve at least 4 (out of 5) stars. 5 stars are awarded to funds that belong to the top 10% of the category’s risk-adjusted returns, while 4 stars are awarded to funds that achieved a risk-adjusted return in line with the next 22.5%. Therefore, by investing only in 4- and 5-star rated funds you only include funds that belonged to the top third in their category (in the past). Bear in mind though that past performance is never a good indicator of future performance and we can only hope that the “good” funds will continue to be lucky. (This information can be found in the subsection “Portfolio”)

There are many many other things you can learn about the fund of your choice, including important facts about the world regions and economy sectors your fund invests in (Portfolio section). You can also learn about the top 10 holdings of each fund in terms of weighting (i.e. the shares that the fund has most heavily invested in) and get a more detailed break-down of the market-capitalisation represented within your fund. Unless you are very keen and good with Excel I suggest you make use of a very useful tool on the Morningstar website called “Instant X-Ray“.

This tool gives you an overview of your portfolio once you have decided which funds to include and what percentage of your portfolio those funds will assume. After running Instant X-Ray you will have a much better idea of how well you diversified across regions, sectors, styles, risk and so forth. Once I finish my fund allocation for the life insurance, I’ll post my X-Ray results so you get a better idea of what I’m talking about.

In my next post on this topic I will compare two funds to see which one is better suitable as a base fund for your portfolio.

Bookmark It

Hide Sites

I recently mentioned that I wanted to change the fund allocation of my life insurance and a couple of days ago I finally sat down with a list of available funds to figure out which ones to include. Since the selection is limited by the life insurance company to about 50, this is a much easier task than starting from scratch and having to navigate through the vast amount of mutual funds available. Nevertheless, the same criteria apply and I have compiled a list of features that I’ve checked before making final decisions.

If you’re completely new to investing, I suggest you familiarise yourself with the Morningstar website, which I think is one of the best and most comprehensive websites available for fund comparison. And most importantly, the key features are completely free of charge.

Assuming you have a list of funds that - for one reason or the other - seem attractive to you, here’s what I look at to determine whether or not to include them in my portfolio (or life insurance in my case). The list is not meant to be in order of importance; it simply reflects the order I’ve looked at information. All of the following are (almost) equally important and should be considered in a bigger context to see whether you end up with a sound overall performance picture.

Morningstar Category. Each fund is classified by assigning it to a main category that most closely reflects its purpose, e.g. UK Large-Cap, India Equity or Sector Equity Biotechnology. Using the categories is also a good way to start looking for certain additions to your portfolio as you should have a good idea what sort of countries or sectors you’re after. If you don’t, I suggest you do some more reading and get yourself a model portfolio that can be used as an initial guideline. Mine is here. When selecting funds, make sure you are diversifying across different categories and don’t rely too heavily on a single selection. (This information can be found on the fund overview page)

Returns. We’re trying to earn some money, so surely the actual returns that a particular fund has achieved are important. I usually look at the 3-year mean return to see how the fund performed in the recent past. Some people look back even further than that (5 or 10 years), but if you do certain other considerations like the fund management should be researched as well. The key point is that you should avoid the “best fund picks” of the year, especially if they have only achieved mediocre performances before. We’re looking for stable long-term performance and many funds that outperform the market this year will underperform it subsequently. (This information can be found on the fund overview page and in the subsection “Risk and Rating”)

Volatility. Those of you, who have read my chapter reviews for Richard Ferri’s book “All About Asset Allocation” will know that we want to reduce volatility in order to maximise long-term returns. Volatility measures the degree to which you can expect your returns to deviate from the average. The lower the volatility, the more likely you are to achieve a certain return. There will often be a trade-off between return and volatility and it is essentially a personal decision how much risk you feel comfortable with. Regardless what you decide, you should always opt for funds with lower volatility given the same return. (This information can be found in the subsection “Risk and Rating”)

Costs. There is no such thing as a free lunch and you will have to pay your fund manager for his (or her) work by paying an annual administration fee. This fee varies considerably and also depends on whether your fund is actively or passively managed. You should only pay a higher admin fee if you are convinced (and the numbers prove it at least for the past) that the fund will severely outperform the index. Otherwise you might as well invest in an index fund. When you compare funds, make sure you always compare the net return, i.e. the annual return minus the annual management fee. Only then you have a true picture of how successful your investment strategy was / would be.

Another important cost factor to look out for is the initial charge some funds require. This is usually give as a percentage of the money you’re investing and can exceed 5% quite easily. Again, don’t forget that the fund has to earn back any money you paid before you can make any profits. Therefore, you should only pay this fee if you are convinced of your choice, or else opt for a no-load mutual fund which doesn’t charge the initial fee. On the other hand, many fund supermarkets (online websites you can use to buy funds) have special deals that significantly reduce these upfront charges. Make sure you shop around! (This information can be found in the subsection “Fees”)

There’s plenty of other things to consider before buying a particular fund, so make sure you check back for more evaluation criteria in part 2!

Bookmark It

Hide Sites

When I went home to visit my parents last weekend, I had the chance to chat to their financial advisor about investing and personal finance in general. And he made a very good point that I hadn’t considered before.

He claimed that many passively managed funds (i.e. index funds) aren’t necessarily as passively managed as we would like to believe and that this situation would become even more obvious if everyone suddenly decided to “do what they’re told” and invest all their money in index funds…

Why is that? Let’s think about this for a minute. What is an index fund? A fund manager trying to copy a stock index’s performance as closely as possible by buying similar or even exactly the same securities that are represented in the index. But the index itself is a benchmark instrument put together by companies… FTSE, S&P or NASDAQ are all companies specialising in compiling various stock market indices.

So what happens if everyone ditches actively managed mutual funds in favour of so-called index funds? The answer seems simple if you think about it. What effectively happens is that the money-making business now resides with index companies instead of fund managers. And as a consequence more indices get compiled which fund managers can then passively follow. But the index itself remains actively managed and therefore the whole point of index funds evaporates.

Do you agree?

Bookmark It

Hide Sites

I don’t know about you but I’m starting to feel a little dizzy with all these investment options available. Until I’ve properly tackled all the options I’ve covered so far, I decided to not add any more to the (already) extensive list.

Of course I could go on talking about options, futures, exotic derivatives, commodities, currencies, real estate… but since I don’t see myself investing in any of those very soon, I won’t bother researching any details on them - yet.

In case you’ve missed a post of the “Investment Choices” series, here a brief overview:

• Shares: a very gentle introduction to what shares/stocks are
• ETFs: a first dive into the world of funds with exchange traded funds
• Index funds: passively-manged funds that aim to track the performance of a stock index. Commonly called “tracker funds” in the UK.
• Mutual funds: actively-managed funds where the fund manager picks shares in order to beat the stock market or achieve a certain objective. In the UK referred to as “investment trusts”.
• Bonds - part 1 and part 2: an excursion into debt securities with a gentle reminder that - assuming you’re young - this investment should by no means dominate your portfolio since the associated low risk won’t earn you decent (enough) returns.
• Bond funds: through the advantages of debt securities joined with the advantages of funds, bond funds are a good way of generating passive income.
• Unit trusts: UK investment jargon explained - part 1
• Investment trusts: UK investment jargon explained - part 2
• OEICs: UK investment jargon explained - part 3

Reading through the above list I feel re-confirmed that there are plenty of options to choose from when building a first portfolio. Let me know if you disagree or want to know more about anything else I haven’t covered so far!

Bookmark It

Hide Sites