A T R U S T N E T D I R E C T P U B L I C AT I O N
ISSUE 14 SEPTEMBER 2014
TH E
PAA VSCT SS IVE IV E DEBATE
CONT 8
STOCKPICKING
Off the beaten tracker
COVER STORY
Our guide to understanding the differences between index trackers and exchange traded funds (ETFs).
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Blue chips on the cheap The cheap FTSE 100 stocks the experts are buying.
The active versus passive debate.
Trustnet Direct’s fund of the month FE Research analyst Thomas McMahon reveals the fund he’s backing in the current market.
EDITOR’S NOTE
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The active versus passive debate rages on. Which side of the fence are you on?
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THE BIG PICTURE “MACRO AND CHEESE”
Investazine’s Daniel Lanyon looks at the global events affecting your portfolio.
10 13
PORTFOLIO MANAGEMENT IN ASSOCIATION WITH TRUSTNET DIRECT
The voice of Trustnet Direct: Man vs Machine
15 17
Head of Trustnet Direct John Blowers weighs in on the active versus passive argument.
A happy medium? Gary Jackson explains how to multiply your returns without taking on much more risk than the FTSE 100.
TENTS Cheap and Cheerful
The cheapest actively managed funds on the market. Do you own any of these bargains?
The cheaper way to build a £15,000 ISA A must-read for investors looking to go down the passive route. Find out how you can build a cheap ISA from passive funds.
Exotic allure
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It takes two to tango
28 32
The unique, quirky and out of this world investment areas only passive funds can give you access to.
ANALYSIS
And the beta goes on
35 38
What exactly is smart beta and how can you use it to enhance your portfolio’s risk/return profile?
Follow the leader
ANALYSIS
When a star fund manager leaves, do you follow in his or her footsteps or stay put? Iona Bain investigates.
A how-to guide to blending active and passive funds from Rathbones’ Mona Shah.
Leaving the past behind If past performance isn’t a guide to future returns, how can you pick a good active fund manager? Read our list of what to look for in a money manager.
COMMENT
The active versus passive debate
41 45 48 54 56
Three financial experts go head-to-head with their views on active and passive funds.
Dividend of the world The hunt for income is on. Lowes Financial Management’s Phil Milburn explains why you should go global.
Access all areas
Find out which vehicles are better for accessing niche investment areas: investment trusts or ETFs.
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We search widely. Murray International Trust ISA and Share Plan Plotting a path between defending your capital and generating a good income needs an expert sense of direction. At Murray International Trust, we know how to explore the world searching for those companies that may deliver the right combination of capital preservation and income generation. And because we insist on meeting every company in whose shares we look to invest, you can be confident we are guiding you to potentially the best investments we can find. Please remember, the value of shares and the income from them can go down as well as up and you may get back less than the amount invested. No recommendation is made, positive or otherwise, regarding the ISA and Share Plan. The value of tax benefits depends on individual circumstances and the favourable tax treatment for ISAs may not be maintained. We recommend you seek financial advice prior to making an investment decision.
Request a brochure: 0500 00 40 00 murray-intl.co.uk
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Please quote MINT TNM 01
JENNA VOIGT
TRUSTNET DIRECT INVESTAZINE Investazine is published by the team behind FE Trustnet in Soho, London. Website: www.trustnet.com Email: editorial@trustnet.com
CONTACTS Editorial Jenna Voigt, Editor Direct line: 0207 534 7661 Alex Paget, Reporter Direct line: 0207 534 7696 Thomas McMahon, Reporter Direct line: 0207 534 7697 Daniel Lanyon, Reporter Direct line: 0207 534 7640 General Pascal Dowling, Head of publishing content Direct line: 0207 534 7657 Advertising Richard Fletcher, Head of publishing sales Richard Casemore, Account manager Direct line: 0207 534 7669 Jack Elia, Account manager Direct line: 0207 534 7698 Photos supplied by Thinkstock and Photoshot
It’s easy to forget about the dangers lurking beneath the surface when markets are rising. At times like this, when sentiment is generally positive, volatility is low and things appear to be looking up for the global economy, money pours into passive, indextracking funds. Last month tracker funds saw record inflows from investors, raking in more than £530m. On one hand this makes sense – trackers allow investors to capture strong gains without the hefty costs often associated with actively managed funds. The danger is that when markets fall, passive funds will tumble along with them. In this issue, Investazine is jumping into the active versus passive debate to help you understand what role each type of fund performs in your portfolio. We explain the difference between index trackers and ETFs (exchange traded funds), pick out some of the cheapest actively managed funds on the market and point out why underperformance can actually be a good thing. We’ll explain! Financial experts Simon Evan-Cook from Premier Asset Management and Nutmeg’s Shaun Port have put on their boxing gloves to duke out the old active versus passive argument, with Whitechurch’s Gavin Haynes caught somewhere in the middle. Thanks for downloading this issue of Investazine. Now that the summer holidays are over and the children are back in school, life is busier than ever and staying abreast of the latest investment research isn’t easy. To be sure you don’t miss an issue, subscribe today and your copy of Investazine will be automatically downloaded to your device of choice each month. Welcome back! Jenna
THE BIG PICTURE
MACRO & CHEESE DANIEL LANYON
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Over the last month, while trading volumes have declined across developed markets, tensions have been ramping up in the UK ahead of the monumental vote on Scottish Independence. The dust is yet to settle from the Scottish votes that will decide the future of the UK. However, that has not stopped the political risk posed by the long list of unknown outcomes from making its presence felt in markets. Most managers and investors had priced in a no-vote over the past year, but more recently it’s been a closely fought race that has seen a narrowing of the polls to almost even odds. There has been a reevaluation of the possibility that Scotland may leave the 300-yearold union. Sterling sank to its lowest level in almost a year the day after a Yougov poll indicated those that
will vote “yes” account for 51 per cent of the electorate, a majority for the first time. Ultimately it remains to be seen what the effect on markets will be in either scenario. It therefore falls on investors to make the call on whether to take money off the table in case the market is further spooked or load up on some of the Scotland-based stocks in the belief the market is behaving irrationally. A weaker pound could also see a re-rating for many larger companies’ share prices, particularly those that derive a significant chunk of their earnings from overseas. In fact, several poor performers in the FTSE 100 such as WPP posted profit downgrades for the second quarter of 2014 due to the strength of sterling over this period.
The uncertainty continues next year, as the UK, or perhaps the former UK, readies itself for the 2015 general election. In what will be a closely fought race between the Conservatives and Labour, with the
Lib Dems probably playing kingmaker for the second time in a row, markets may well be set for greater volatility. Politically sensitive areas of the market such as housing and energy could be hit as the national debate ignites. Nationalist politics and their potential to knock back markets have been a wider theme this year, most notably with the stand-off, quickly escalating into a bloody conflict, between Russia and the Ukraine over the former’s annexation of the Crimean Peninsula. A peculiarity has been that with all the geopolitical risk from the Middle East to Ukraine and Edinburgh is that for most of the year, its effect on wider markets has been subdued. Oil has not seen a prolonged spike and the market has not sold off. However, a key string that Russia can pull is its supply of gas to Europe. This has not been a huge issue over a particularly balmy summer, but as we go into winter we could see a greater synergy between political risk and market behaviour.
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STOCKPICKING
JENNA VOIGT
Off the beaten tracker You’ve made the decision to invest in a passive fund, but which vehicle is the right one for you?
When it comes to putting your money away for the long-term, there are a number of different routes you can take. Most savers will lock away their cash in a pension or use an ISA to build up savings over time. Under the new rules, investors can hold up to £15,000 in a stocks and shares ISA, making it easier for them to build up a healthy pot. While actively managed funds – ones that are headed up by a fund manager who makes day-today decisions about the holdings – can outperform the market, they levy much higher charges for the service they provide than their passively managed counterparts. An increasingly popular passive investment vehicle is the exchange traded fund, or ETF for short. Index funds aim to match, or “track”, the performance of a relevant benchmark index, such as the FTSE All Share in the
UK. They do this by investing in a near equal weighting to the constituents of the index, as with the FTSE 100, or to a representative index in the case of larger indices or more niche areas of the market. An ETF, on the other hand, is essentially a bundle of investments that is traded like stocks on an exchange. It is made up of a fund that tracks an index, a commodity or a basket of assets, much like open-ended funds. However, the price of an ETF changes throughout the day, rather than having a daily calculated price like index funds. Both index funds and ETFs will rise in line with their relative
index, but they are also subject to the same falls that the index may experience. So which product type is a better option for retail investors?
Simplicity Most retail investors will prefer index funds because they are simple. Anyone who wants to buy an ETF will need to use a middleman in the form of a broker, while index funds can be bought through an investor’s bank.
Costs Index tracking funds are cheap compared with most actively managed funds, but ETFs are even cheaper in terms of both headline total expense ratio (TER) and ongoing charges figure (OCF).
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However, investors should not discount trading costs, which are difficult to calculate up front and present a problem for anyone looking for simplicity. Brokerage firms that buy and sell ETFs will charge a trading commission, just like for a stock, and if investors frequently move in and out of ETFs, the charges will add up. There are a few ETF providers that have introduced commission-free trading models, which remove one of the key disadvantages to investing in the products. Investors can also put as much or as little money as they want into an ETF because they carry no minimum investment level.
Dividends While ETFs are generally cheaper than index funds, when it comes to dividends, the latter have a clear advantage.
Index funds reinvest their dividends immediately while ETFs distribute their cash quarterly. This means that ETFs have to stockpile cash over this period, missing out on the compounding effect offered through index funds. This compounding will often mean higher returns for index funds, even though they track the same underlying index.
Taxes While US investors can take advantage of tax breaks associated with ETFs, this is not the case in the UK – index funds and ETFs are treated the same in this regard, so investors will receive no special tax relief by investing in the latter. If UK investors buy US or European-listed ETFs, they may be required to pay even more tax than they would by investing in a UK-listed index fund.
In the US, investors are subject to withholding tax, which taxes dividends from ETFs by as much as 30 per cent.
Niche exposure ETFs offer a unique advantage to the more adventurous investor. Like investment trusts, they can access many hard-to-reach sectors and areas of the world. One ETF tracks the coffee market, for all the caffeine junkies out there, and there is even an ETF that tracks companies that focus their products and services on combating global warming. If you want to invest in it, there’s probably an ETF out there for you. Just remember, your investments can fall as easily as they rise.
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STOCKPICKING
JENNA VOIGT
BLUE CHIPS ON THE CHEAP Three cheap FTSE 100 stocks the experts are buying The FTSE 100 is currently a popular hunting ground for fund managers keen to recycle profits from top-performing medium-sized companies, which have led the recent rally. As always, some stocks are cheaper than others, and a handful in the index are trading at historic lows on a price-to-earnings basis. Here we reveal three cheap FTSE 100 stocks that fund managers are backing in large quantities, some of them among the highest profile in the industry.
Rolls Royce This income-paying stalwart issued its first profit warning in a decade earlier this year and results continue to be lacklustre today. Rolls Royce has shed more than 17 per cent of its share price since the start of the year and has underperformed the FTSE 100 by nearly 20 percentage points.
Year-to-date performance of stock vs index* 5% B
0% -5% -10% -15%
A -20% -25% Jan 14
A – Rolls Royce (-17.4%) B – FTSE 100 (0.5%) Aug 31 December 2013 – 8 August 2014 © Powered by data from FE 2014
Source: Trustnet Direct
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However, Jeremy Thomas, comanager of the Brunner Investment Trust, says there is a compelling long-term opportunity to buy in at the current low valuation, despite all the negativity. “The long-term opportunity for Rolls-Royce is clear, with a £70bn order book, a market share in large civil aerospace engines in excess of 50 per cent, high margin aftermarket revenues and the potential to improve group margins meaningfully,” he said. “As the chief executive John Rishton acknowledges, today Rolls Royce is suffering some growing pains and this short-term discomfort gives investors an opportunity to buy a long-term winner at an attractive price.” Rolls Royce is currently trading on a P/E ratio of 16, which is nearly the cheapest it has been in more than five years, although the discount has come in slightly from 2013. The stock is trading on a forward P/E of just 11 times. Rolls Royce’s long-term performance speaks for itself: the stock is up 488.57 per cent over the last decade compared with 119.63 per cent from the FTSE 100.
Neil Woodford is backing Rolls Royce in the top-10 of his CF Woodford Equity Income fund, as is FE Alpha Manager Mark Barnett in Invesco Perpetual Income and Invesco Perpetual High Income, which he took over from Woodford earlier this year. FE Alpha Manager Julie Dean is another fan, with 3.04 per cent of her Schroder UK Opps fund in the stock. In total, 30 funds in the IMA universe hold Rolls Royce in their top 10.
Royal Dutch Shell Royal Dutch Shell is still a long way off its historical high despite its strong performance this year, which analysts says makes its share price look like good value. It is on a forward P/E of just 11 times, making it significantly cheaper than the wider index.
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The Share Centre’s Helal Miah rates the stock as a “buy” after its second-quarter earnings more than doubled last year’s figure. He also likes the 4.9 per cent dividend yield.
Alpha Manager duo Adrian Frost and Adrian Gosden in Artemis Income. It is particularly popular among value managers such as Alastair Mundy and Tom Dobell, who hold it in Investec Special Situations and M&G Recovery, respectively.
“We recommend the company as a medium-risk ‘buy’ for investors as the group’s management has prioritised streamlining its operations through asset disposals and capital efficiency, along with delivering on expansion projects,” he said. “We believe Royal Dutch Shell still represents a core holding for most portfolios due to the relatively stable cash-flows and the attractive dividend income it generates.”
Much to my dismay, the stock I tipped at the start of the year has seen its share price tumble.
Royal Dutch Shell is up 12.59 per cent year-to-date, ahead of the index.
Like other food retailers, Tesco has seen its share price suffer from the threat of a price war in the sector and the competitive squeeze from discount retailers such as Aldi and Lidl.
Year-to-date performance of stock vs index 16% 14%
A
12% 10% 8% 6% 4% 2%
B
0% -2% -4%
A – Royal Dutch Shell (12.6%) B – FTSE 100 (0.5%)
-6% Jan 14
Aug
31 December 2013 – 12 August 2014 © Powered by data from FE 2014
Source: Trustnet Direct
However, this comes after several years of lacklustre performance. The stock trailed the index in 2013 and shed 7.01 per cent in 2012 while the index was up 9.97 per cent. Royal Dutch Shell’s returns of 36.10 per cent over the past three years are lower than the FTSE 100’s 38.88 per cent. The stock is a staple in many equity portfolios, with 403 funds holding it in their top 10. Richard Buxton holds the stock in his Old Mutual UK Alpha fund, as do FE
It is down nearly 25 per cent year-to-date, with the losses becoming even more pronounced in the summer months.
However, some of the UK’s leading managers say all the negative sentiment surrounding the supermarkets makes it the perfect time for contrarian investors to make a bet.
“From a valuation perspective, supermarkets haven’t been cheaper on an absolute and relative basis in the past 20 years,” said John Stopford, cohead of Investec’s multi-asset investment team. “In a low interest-rate environment where the demand for income remains high and rising, the UK supermarkets represent a potentially attractive contrarian value opportunity. [We] began to buy Tesco and Morrisons earlier this year, and following this, our own due diligence work has highlighted significant re-rating and growth potential on a two- to three-year view.” Stopford adds that the supermarkets are extremely under-owned and oversold, which are good signs for contrarian investors. “Tesco and Morrisons currently have the highest number of ‘sell’ and the lowest number of ‘buy’ recommendations among the sell-side community since 1999,” he said. “This is similar to 2008 for Tesco and 2005 for Morrisons, prior to strong rallies in their shares.” The stock is trading on a forward P/E ratio of 10.04.
Nineteen funds in the IMA universe hold Tesco in their top-10, including value manager duo Kevin Year-to-date performance of stock vs index Murphy and Nick Kirrage’s Schroder Income fund. 5%
B
0%
-5%
-10%
*Data to 13 August 2014.
-15%
-20%
-25% Jan 14
A – Tesco (-24.8%) B – FTSE 100 (0.5%)
A
Aug
31 December 2013 – 12 August 2014 © Powered by data from FE 2014
Source: Trustnet Direct
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STOCKPICKING — TRUSTNET DIRECT FUND IN FOCUS
THOMAS MCMAHON
FE Research analyst Thomas McMahon reveals the fund he is tipping for the long-term.
RATHBONE INCOME
CARL STICK
While sentiment in the markets remains generally positive, 2014 has been a year of increased uncertainty and volatility. However, investors are still wont to find desirable levels of capital growth and income from bonds, and savers are still losing money by leaving cash in the bank. Most investors still favour equities in spite of the uncertainty in the market.
Ongoing charges: 0.80% 100%
A
90% 80%
B C
70% 60% 50% 40% 30% 20% 10% 0% -10%
A – Rathbone Income (95.6%) B – IMA UK Equity Income (78.3%) C – FTSE All Share (74.9%) Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 1 September 2009 – 1 September 2014 © Powered by data from FE 2014
Source: Trustnet Direct
FE Research analyst Thomas McMahon says a fund such as Rathbone Income should hold up well over the long-term, particularly in volatile markets, because manager Carl Stick is so focused on avoiding capital losses.
“Carl Stick’s approach should appeal to investors concerned about the ambiguity in the markets,” McMahon said. “On the one hand the UK economy is improving, on the other hand, rate rises are feared by many investors, while geopolitics are weighing heavily on the markets.” “Stick’s approach is to admit that he cannot foresee the future and prepare his portfolio for the major risks that he can see.” “He seeks to balance price risk, financial risk and business risk in his positions, and establish a margin of safety to prevent the permanent loss of capital. This has helped the fund in the difficult conditions this year, as he has outperformed during a sideways market, with lower volatility than his benchmark and peers.” Stick’s focus on avoiding permanent capital losses came from the lessons he learned in the financial crisis of 2008, when the fund was hard hit by the selloff in the financial sector. Stick has kept a close eye on risk ever since, which has helped him to deliver top-quartile returns over the last three and five years, with a low level of volatility.
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SCOTTISH MORTGAGE INVESTMENT TRUST
SCOTTISH MORTGAGE WAS ORIGINALLY LAUNCHED TO PROVIDE LOANS TO RUBBER GROWERS IN MALAYSIA IN THE EARLY 20TH CENTURY.
While others stick to the indices, we are free to choose. Scottish Mortgage Investment Trust has its own way of doing things. So it’s hardly surprising that the Trust’s portfolio looks nothing like the index, after all, we are active rather than passive investors and we firmly believe that the index is an illustration of ‘past glories’ rather than future prospects. In fact, our abiding principle has always been to invest in tomorrow’s companies today. We give ourselves time to add value by being patient investors in an impatient world. But don’t just take our word for it, over the last five years Scottish Mortgage has delivered a total return of 225.7%* compared to 100.7%* for the index. And Scottish Mortgage is low-cost with an ongoing charges figure of just 0.50%†.
Standardised past performance to 31 March each year**: 2009-2010 2010-2011 2011-2012 2012-2013 2013-2014 Scottish Mortgage
76.6%
24.2%
-2.9%
18.5%
28.9%
FTSE All-World Index
48.4%
8.4%
-0.2%
17.1%
6.8%
Past performance is not a guide to future performance. Scottish Mortgage Investment Trust is managed by Baillie Gifford and is available through our Share Plan and ISA. Please remember that changing stock market conditions and currency exchange rates will affect the value of your investment in the fund and any income from it. You may not get back the amount invested.
GLOBAL GROWTH Scottish Mortgage Investment Trust
For a free-thinking investment approach call 0800 917 2112 or visit www.scottishmortgageit.com
Baillie Gifford – long-term investment partners *Source: Morningstar, share price, total return as at 31.03.14. †Ongoing charges as at 31.03.14. **Source: Morningstar, share price, total return. Your call may be recorded for training or monitoring purposes. Baillie Gifford Savings Management Limited (BGSM) is the manager of the Baillie Gifford Investment Trust Share Plan and the Investment Trust ISA and is wholly owned by Baillie Gifford & Co, which is the manager and secretary of the Scottish Mortgage Investment Trust PLC. Your personal data is held and used by BGSM in accordance with data protection legislation. We may use your information to send you information about Baillie Gifford products, funds or special offers and to contact you for business research purposes. We will only disclose your information to other companies within the Baillie Gifford group and to agents appointed by us for these purposes. You can withdraw your consent to receiving further marketing communications from us and to being contacted for business research purposes at any time. You also have the right to review and amend your data at any time.
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VOICE OF TRUSTNET DIRECT
MAN vs MACHINE JOHN BLOWERS HEAD OF TRUSTNET DIRECT The fund management industry has been at war for years now. The war is hidden, and mostly fought internally, but every now and again a wily journalist will pop up and bring it to the attention of the investing public. The war in question is: which is better, active or passive fund management? For the benefit of jargonhaters, active management is where we pay handsomely for a professional fund manager to try to make outsized returns from the market. They are tasked with “beating their index” and for this service a fund manager will typically skim off 0.75 per cent of your investment every year. Passive funds dispense with the highly paid fund manager and essentially track an index, such as the FTSE 100, either here or around the world.
All these funds do is hold the stocks contained in that index in the appropriate ratios, so that if the FTSE 100 goes up by 10 per cent, then the FTSE 100 fund (known as a passive or tracker fund) should go up by 10 per cent too. This type of fund is now traded by computer algorithms, ensuring that its holdings represent the index it is tracking and greatly reducing the annual cost of holding it. Exchange traded funds, or ETFs, now offer ultra-low cost investments into all the main indices around the world. The current best performer over three years is the Source Health Care S&P US Select, whose objective is to replicate the performance of the S&P Select Sector Capped 20% Health Care Total Return (Net) Index. Specialist or what? But this ETF is up 99.73 per cent over the last three years and has a total ongoing charges figure of just 0.3 per cent. Compare that with the best-performing unit trust/ OEIC (Polar Capital’s Healthcare Opportunities fund), which has an ongoing charges figure of 1.24
per cent per annum – that’s a big difference. Woooaaaah! Before you press the buy-button, the Polar Capital fund – clearly investing in the same sector of healthcare as the source ETF – has returned 131.78 per cent over three years, a whopping 30 percentage points more than the ETF – and that’s after the charges have been factored in. So it’s man versus machine, and in this example, the man seems to have won. Or men in this case: Dan Mahony and Gareth Powell to be precise. I have no idea what the source ETF’s computer is called. Industry experts often say that you should never choose a fund based on the charges it levies. If a fund can consistently demonstrate above-average performance, it should easily mitigate the cost. You get what you pay for. So which way should you jump? The answer, as always, is that it depends. There is no clear answer to which types of fund perform better on average. Passive and actively managed funds broadly perform similarly in aggregate.
But what is clear is that good actively managed funds always have the ability to perform better than an index and poorly managed funds always have the ability to perform worse, so, on average, they perform the same. A passive fund should deliver the same returns as an index. What is clear is that if you want to outperform the market, you need to pick a high quality manager running a high quality fund and that is why so much effort goes into rating funds and their managers. At Trustnet Direct, we use two quantitative methods to evaluate the fund and the manager, borrowed from our parent company, FE. Our FE Crown Fund Rating reflects the consistency of fund performance, while our FE Alpha Manager rating judges managers against their peers. Together, these ratings can provide an insight into whether a fund has historically performed better than others and whether it is likely to continue to do so in the future. Passive, ETF or tracker funds should be judged on how accurately they track their chosen index.
Performance figures correct on 5th August 2014 Useful links Guide to passive funds Fund filter
RATINGS YOU CAN COUNT ON We identify the best funds and fund managers, so you can focus on the best possible service for your clients.
FE Crown Fund Rating
FE Alpha Manager Rating
FE – THE ADVISERS’ CHOICE* Find out more at trustnet.com/ratings2014
*UK advisers’ preferred choice of research and ratings (source: The Platforum Adviser Survey, July 2013).
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TRUSTNET DIRECT PORTFOLIO MANAGEMENT
GARY JACKSON
A happy medium? Can mid caps offer better returns without added risk?
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Mid cap stocks have been the focus of much investor attention over recent years, as the recent equity bull run has led people to flock to the asset class. Investing in UK mid caps, which make up the FTSE 250 index, offers the prospect of higher returns than the country’s largest companies without taking on much more risk. Investment experts have, however, warned that short-term losses could deliver a sucker punch – the sector could be even more vulnerable when the Bank of England finally lifts interest rates
on volatility as this sometimes hides the risk. What you want to look at is measures like maximum drawdown, which would show how much you would have lost in bad periods.” Performance of indices in H1 2014 4% 3% 2%
0% -1% -2% -3% -4%
The FTSE 250 has enjoyed a strong rally recently, picking up nearly 150 per cent over the five years to the end of June. This is compared with just 89.57 per cent from the FTSE 100 over the same period. Performance of indices over 5 years 110% 100%
B A
90% 80% 70%
A B
1%
A – FTSE 100 (1.9%) B – FTSE 250 (1.6%)
-5% Jan 14
Jun
31 December 2013 – 30 June 2014 © Powered by data from FE 2014
Source: FE Analytics
The maximum drawdown, which measures the most you would have lost if you bought at the top of the market and sold at the bottom, of the FTSE 250 over the five years examined was 19.26 per cent, compared with 15.76 per cent for the FTSE 100
60% 50% 40% 30% 20% 10%
A – FTSE 100 (89.6%) B – FTSE 250 (96.7%)
0% -10%
Jan 10
Jan 11
Jan 12
Jan 13
Jan 14
Jun
30 June 2009 – 30 June 2014 © Powered by data from FE 2014
Source: FE Analytics
Investors in mid caps did not have to endure much more volatility than the FTSE 100 in achieving these returns. The average mid cap fund has annualised volatility, a measure of the dispersion of returns for an index, of 16.8 per cent over the five years in question, barely above the 15.48 per cent for the FTSE 100. The raw index was more volatile than actively managed funds in the IMA All Companies sector, which averaged 14.73 per cent. Despite this seemingly attractive risk/reward ratio, Equilibrium Asset Management’s Mike Deverell points out that investing in mid caps can still be a riskier proposition: “You have to be careful when focusing
“You have to be careful when focusing on volatility.” Mike Deverell, Equilibrium Asset Management
Widening the time frame to cover the financial crisis, the FTSE 250’s maximum drawdown was 52.94 per cent – more than the 44.46 per cent lost by the FTSE 100. Mid caps have also made a stuttering start to 2014, with the average fund falling by 1.84 per cent over the first six months and the FTSE 250 down 0.02 per cent. The FTSE 100, on the other hand, rose by 1.9 per cent. Despite the recent fall, commentators argue that UK mid caps still have many advantages over their larger counterparts. Helal Miah, investment research analyst at The Share Centre, points out that the gross profits of UK companies reporting at the end of the second quarter rose just 0.2 per cent year-onyear, despite some promising sales growth. However, this disappointing result was mainly down to the poor performance of the country’s largest firms. “Mid caps are storming ahead of the top 100 at every level, from revenues to profits. Mid caps are reaping the benefits of growth in the domestic economy, while their larger counterparts are more
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exposed to foreign markets and to the exceptionally strong pound, the strongest currency in the world in the last year,” Miah said.
cap portfolios in its Academy of Funds – Michael Ulrich’s F&C UK Mid Cap, Paul Spencer’s Franklin UK Mid Cap and Richard Watts’ Old Mutual UK Mid Cap. Ulrich and Spencer are FE Alpha Managers.
“Mid caps are storming ahead of the top 100 at every level, from revenues to profits.” Helal Miah, The Share Centre “With the UK economy recovering quickly, middle-ranking firms are clearly benefiting. While the global economy is sluggish and currency headwinds persist, it will take longer for their global counterparts to catch up.” Investors looking to allocate specifically to UK mid caps have a number of options. There are eight actively managed funds with a track record of longer than five years, while there is one tracker and a number of ETFs. While trackers and ETFs aim to replicate the index as closely as possible, investors should be aware that there can be large differences between the holdings and performance of actively managed funds, although past returns are no guide to the future. For example, the F&C UK Mid Cap fund was up 175.20 per cent over the five years to the end of June; in contrast, the Threadneedle UK Mid 250 rose 124.77 per cent. Over the difficult first six months of 2014, not a single active fund beat the index. Square Mile Investment Consulting & Research recommends three active mid
Tilney Bestinvest’s Jason Hollands highlights Chris St John’s AXA Framlington UK Mid-Cap fund as another option. Despite being a “minnow” at just £72.7m in size, the 1 fund has the highly regarded FE Alpha Manager Nigel Thomas as deputy. 2 However, Hollands issued a note of caution: “Having been heavily weighted to mid caps, we’ve reduced this in recent months based on valuation grounds and concerns that momentum in domestic earnings may be slowing. Across the market, there’s been quite a major rotation from mid caps into FTSE 100 stocks.” “Some of the valuation pressure has therefore come off mid caps in recent months, but I would be a little careful about taking an aggressively contrarian approach to asset allocating into these as this part of the market is likely to be more vulnerable to any negative reaction from future UK interest rate rises.”
Special Situations as funds that have more than 30 per cent in UK mid caps, while Deverell notes that Artemis UK Special Situations and Miton UK Value Opportunities have “reasonable” exposure to this part of the market.
Actively Managed FTSE 250 funds Aberdeen UK Mid Cap Equity Allianz UK Mid Cap
3
F&C UK Mid Cap
4
Franklin UK Mid Cap
5
Old Mutual UK Mid Cap
6
Royal London UK Mid-Cap Growth
7
Schroder UK Mid 250
8
Threadneedle UK Mid 250 Source: FE Analytics
Both Deverell and Hollands prefer to get mid cap exposure through multi-cap funds, which have the flexibility to invest wherever they see the best opportunities. Hollands highlights AXA Framlington UK Select Opportunities, JO Hambro UK Opportunities and Liontrust 19
TRUSTNET DIRECT PORTFOLIO MANAGEMENT
Cheap & JOSHUA AUSDEN
Advantages of clean share classes Lower fund charges Transparent fee structure Potential improvement in fund performance due to lower charges Easier comparison of charges between funds *Source: The Share Centre
Want active management but don’t want to pay over the odds? We reveal five cheap but highly rated funds to cover all the major global markets. Clean share classes have been on the agenda for many years now, but it has only been in recent months that platforms and indeed journalists have begun to use them widely in the context of ongoing charges figures (OCFs). Before new regulation came into place, fund investors historically had to pay financial advisers trail commission deducted from the value of their investments. The charge ranged from roughly 0.1 per cent to 0.9 per cent a year. However, trail commission has been banned under the new regulatory scheme and new clean share classes have been introduced. As a result, charges have come down for actively managed funds across the board. Fund charges now strip out the trail fee, reducing the annual management charge in the region of 1 per cent from the previous figure of approximately 1.5 per cent.
20
cheerful Starting with core equity exposure, we look at some of the bargain options with strong track records across the emerging and developed world. Performance of manager and peer group composite since 2000
UK equities CF Woodford Equity Income attracted more money in its launch period [£1.6bn] than any other fund in history and the inflows haven’t stopped there. Trustnet Direct data shows that the fund has already grown to £2.4bn, making it the fifth largest fund in the IMA UK Equity Income sector already. The biggest lure of the fund is of course Neil Woodford, whose long-term value style has reaped huge rewards since he started running money in 1988. Woodford tends to focus on the UK’s largest companies, taking very large sector and stock bets. Pharma and tobacco giants AstraZeneca, GlaxoSmithKline, British American Tobacco and Imperial Tobacco are among his largest holdings, making up more than one-quarter of his portfolio CF Woodford Equity Income is also cheap, charging investors just 0.75 per cent, which falls to as low as 0.65 per cent on some platforms. This compares with 0.9 per cent from
300.0 250.0 200.0 150.0 100.0 50.0 Neil Woodford [293.17%]
0.0
Peer group composite [92.83%] -50.0
Jan 00
Jul 01
Jan 03
Jul 04
Jan 06
Jul 07
Jan 09
Jul 10
Jan 12
Jul 13
31 December 1999 – 22 August 2014 © Powered by data from FE 2014
Source: Trustnet Direct
arguably its biggest rival, Mark Barnett’s Invesco Perpetual High Income fund. Woodford headed up the portfolio until his exit in March of this year. Another big advantage of this figure is transparency. The 0.75 per cent charge absorbs all trading fees, meaning that investors will never pay more than this figure.
European equities Henderson European Growth is a favourite with FE Research’s Rob Gleeson, who holds it in his personal pension portfolio. It is also a member of the Trustnet Direct Select 100 list. The £996m portfolio has been a strong longterm performer under FE Alpha Manager Richard Pease, achieving top-quartile returns over 10 years Pease and co-manager Simon Rowe run a concentrated portfolio of just 40 stocks, focusing on quality franchises that tend to hold up well during times of stress. 21
This, the FE Research team says, makes it a good option for core European exposure: “The team has extensive experience of identifying companies that can grow steadily over the long-term and become leaders in certain niche markets.”
Performance of fund, sector and index over 10 years 200% 180% 160%
A – Henderson European Growth (178.2%) B – IMA Europe ex UK (134.7%) C – FTSE Europe ex UK (142.4%)
A C B
140% 120% 100% 80% 60% 40% 20% 0% -20%
Jan 05
Jan 06
Jan 07
Jan 08
Jan 09
Jan 10
Jan 11
Jan 12
Jan 13
Jan 14
Aug
28 August 2004 – 28 August 2014 © Powered by data from FE 2014
Source: Trustnet Direct
portfolio of less than 50 stocks. Consumer stocks and tech, telecoms & media make up more than 50 per cent of assets. According to Trustnet Direct data, the fund’s bets have largely paid off since its launch in October 2007.
“The steady nature of the fund makes it a good core holding, despite its decision to focus on mediumsized businesses more than large ones.”
Cormac Weldon left the fund for Artemis earlier this year, but incoming managers Ashish Kochar and Neil Robson are highly regarded.
Henderson European Growth’s extra charges, like the costs incurred for trading, are much lower than most of its competitors’. This means the OCF is currently just 0.85 per cent, which compares with more than 1 per cent for popular choices such as Jupiter European.
The fund is one of the cheaper strong performers in the sector, with ongoing charges of 0.81 per cent.
Emerging markets
North American equities
Emerging markets tend to be more expensive than their developed market rivals, with research costs sending OCFs higher.
It has been notoriously difficult to add value to the US market in recent years, and finding a fund with a low level of charges is an even harder task.
Some groups have made a big effort to make their portfolios competitive compared with even UK and US funds, however.
One fund that has a strong record of beating its benchmark is Threadneedle American Extended Alpha. As its name suggests, this is a high conviction
The standout fund in this regard is Newton Emerging Income, which has ongoing charges of just 0.88 per cent. This makes it cheaper than many 22
developed market-focused core options, including Invesco Perpetual High Income, BlackRock European Dynamic and GAM North American Growth. Performance of fund and sector since launch 25%
A – Newton Emerging Income (5.8%) B – IMA Global Emerging Markets (8.7%)
20% 15% 10%
B A
5% 0% -5% -10%
Jan 13
Jan 14
Aug
£563m Baillie Gifford Japanese portfolio, which is as cheap as 0.68 per cent on most major platforms. The fund, which is top quartile in its IMA Japan sector over three, five and 10 years, aims to balance its assets between large Japanese companies with global strategies and smaller companies that are gaining strength in niche domestic markets Gleeson and his team note that the fund is in many ways similar to other core funds in the sector, with one major difference.
4 October 2012 – 22 August 2014 © Powered by data from FE 2014
Source: Trustnet Direct
The fund, headed up by Sophia Whitbread and Newton Asian Income’s Jason Pidcock, has had a difficult time of late, lagging behind its sector since its launch in October 2012. It remains a popular choice with professional investors, however, and has already attracted £225m in assets. Mexico and South Africa are among Whitbread’s favourite countries, together making up 23 per cent of assets. The manager is wary of direct exposure to China, preferring to get it instead from Hong Kong Independent financial adviser Adrian Lowcock says he likes the team’s bias towards quality companies, noting that the emphasis on dividends will help the fund perform better than its peers when markets hit a rough patch.
“The investment approach used by Baillie Gifford is nothing new; however, the high returns achieved over recent years show the team’s expertise at executing it,” they said. “This highlights the efficient teamwork and superior knowledge of the Japanese equity market.” “FE Research has also been impressed by the team’s consistency: the fund invests for the long-term and is happy sticking with a position over a lengthy period of time.” Performance of fund and sector over 5 years 80% 70%
A
60% 50% 40%
B
30% 20% 10% A – Baillie Gifford Japanese (64.6%) B – IMA Japan (36.6%)
0% -10%
Jan 10
Jan 11
Jan 12
Jan 13
Jan 14
Aug
22 August 2009 – 22 August 2014 © Powered by data from FE 2014
Source: Trustnet Direct
Japanese equities While Japan remains unpopular with investors still hurting from a disastrous period in the late 1980s, 1990s and much of the 2000s, the sector is a good place for bargain hunters. Among the cheapest funds is Sarah Whitley and Matthew Brett’s
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24
COVER
When underperformance is a good thing ALEX PAGET
TH E
PAVSACTI SS VE IV E DEBATE
Active managers who underperform their peers and the market will usually be lambasted by certain pockets of the investor community. You can certainly see why. If a manager has consistently failed to beat the index, why should investors pay their often pricy ongoing charges? Some of the loudest of these critics will then go on to say, in what is usually a dogmatic tone, that
investors should only use passives because the average active fund will fail to consistently beat the market and that even currently outperforming fund managers will eventually “mean revert” back to the norm. They may then go even further, likening fund managers to blindfolded monkeys randomly picking stocks….
25
There are funds out there that will typically only outperform when the market is shooting up, but the hope is that their periods of outperformance will far outweigh their periods of underperformance, meaning they will generate market-beating returns over the longer-term.
“They must have a disciplined approach. If they don’t and they are over-trading, they are probably going to get it wrong.” But the debate isn’t black and white. Yes, there are managers that fully deserve the criticism they receive for their performance and, yes, you are going to really struggle to find an active manager who has never underperformed at some stage, but I think a lot of people are missing the point. Which is – that for any investor who is trying to build a diversified portfolio, every fund included should be in there to fulfil a certain role, not because it should always make you lots of money – as Mike Deverell investment manager at Equilibrium, explains: “If you can find a fund that can consistently outperform, year-in, year-out, then that is a dream. However, usually managers will outperform or underperform in certain market conditions.” “Taking it back a step further, every time you put together an investment portfolio you should set yourself an objective and then blend funds to try to achieve that objective. You want that mixture of funds because certain ones will do well when the market is shooting up, while others will outperform in flat or falling markets.” As Deverell points out, there are times when a fund’s underperformance is healthy for your portfolio, although it may seem strange to say – this is because if all of your holdings go up together, the chances are they are going to fall together just as quickly. Performance of funds vs index over 10yrs 300%
C
250%
A
200%
B
150%
D
100% 50% A – Schroder Recovery(220.4%) B – Fidelity Special Situations(168.8%) C – Unicorn UK Income (254.8%) D – FTSE All Share (131.1%)
0% -50%
Jan 05
Jan 06
Jan 07
Jan 08
Jan 09
Jan 10
Jan 11
Jan 12
Jan 13
Jan 14
Sep
01 September 2004 – 01 September 2014 © Powered by data from FE 2014
Source: FE Analytics
Funds that have demonstrated this ability include Schroder Recovery, Fidelity Special Situations and Unicorn UK Income. Then there are the funds that will look pretty average when the market is rallying, but come into their own when everything else seems to be dropping. Take the likes of Michael Clark’s Fidelity MoneyBuilder Dividend fund and FE Alpha Manager Francis Brooke’s Trojan Income fund, which both made more than 6 per cent in 2011 when the eurozone nearly collapsed and the FTSE 100 fell 4 per cent. However, those two funds have lagged behind the rallying market over the last couple of years. One point that should be made is that a fund’s performance should always be analysed to determine what has driven its returns. For example, M&G Global Basics has underperformed recently, but this is almost entirely because its style has been out of favour. Performance of fund vs sector over 5yrs 70%
B
60% 50% 40%
A
30% 20% 10% A – M & G Global Basics(34.6%) B – IMA Global (60.3%)
0% -10%
Jan 10
Jan 11
Jan 12
Jan 13
Jan 14
Sep
01 September 2009 – 01 September 2014 © Powered by data from FE 2014
Source: FE Analytics
The £2.8bn fund, which used to be run by Graham French and is now headed up by Randeep Somel, has lagged behind the IMA Global sector over one, three and five years. The fund aims to invest in companies that will form the building blocks of an economy and has a high weighting to the developing world. Because of this, a lot of its assets are invested in emerging market equities and mining/commodity stocks. 26
French undoubtedly made a number of stockselection errors during his last few years as manager, but most of the underperformance can be explained by slowing growth in China and other contributing factors that have caused emerging markets and the mining sector to struggle. The fund has outperformed by a significant amount over the longer term. However, it is currently fighting an uphill battle trying to beat a sector that is largely made up of funds with a high exposure to the US, Europe and the UK, which have rallied strongly over the last few years. Investors could argue that they may as well have used a tracker instead of M&G Global Basics, but supporters of the fund will say they use it because of the access it gives them to different markets and that want it to take advantage when emerging SAMthey SHAW markets become flavour of the month once again
During the late 1990s, he firmly believed that technology stocks were in bubble territory, so avoided them while every other manager loaded up on the sector. This damaged the performance of his Invesco Perpetual High Income fund to such an extent that the rumour was that he was about to lose his job. However, he was eventually proved right and the dotcom bubble burst spectacularly in early 2000. Those two years of underperformance now look like a mere blip considering his longer term numbers. Performance of fund vs index Feb 1988 to Mar 2014 1800% 1600%
1200% 1000% 800% 600%
However, it is easy to make these points with the benefit of hindsight and history has proven that some sectors, asset classes and funds can keep underperforming, so when should an investor sell? The first signal the majority of experts point to is when you no longer fully believe in the investment case. If that is the situation, you should probably take what is left of your money and run. Deverell says another signal is when a manager changes their style or performs in a way that they haven’t done in the past. “You have to step back a bit and think, how would an active manager outperform in the first place?” “They must have a disciplined approach. If they don’t and they are over-trading, they are probably going to get it wrong. Also, if a manager changes their style to chase returns, they are going to get it wrong because it isn’t their area of expertise.” It isn’t always that easy to call, however, because some managers have gone through periods of underperformance due to a certain decision, not necessarily because their style has fallen out of favour. One of the best examples is Neil Woodford, who is commonly regarded as among the best managers in the UK.
B
400% 200% 0% -200% Jan 90
WHEN TO SELL
A
A – Invesco Perpetual High Income(1715.6%) B – IMA UK All Companies (517.7%)
1400%
Jan 92
Jan 94
Jan 96
Jan 98
Jan 00
Jan 02
Jan 04
Jan 06
Jan 08
Jan 10
Jan 12
Jan 14
08 February 1988 – 05 March 2014 © Powered by data from FE 2014
Source: FE Analytics
Again, it is easy to look at these events with the benefit of hindsight. Deverell says that if a manager makes a call within his portfolio and has made that decision clear to his investors, then it must come down to the individual’s view on the matter. “In some ways, if as an individual investor you can’t make a call or don’t have the information as to why a fund is underperforming, you shouldn’t be invested in it and you should use a tracker instead,” he said. I’d like to point out that this isn’t an attack on passives, but more a defence of active funds. The key to the success of any portfolio is diversification and one of the best ways investors can achieve this is by using both active and passive funds, as Deverell explains. “The starting point for us is we will have an open mind and look for a fund that can do a certain job in a portfolio. If there isn’t a manager who has demonstrated he can consistently add value, or has done so more by luck than judgement, we will go passive.” “That’s really the default option.”
27
TRUSTNET DIRECT PORTFOLIO MANAGEMENT
The cheaper way to build a £15,000 ISA
PADRAIG FLOYD
With the stocks and shares ISA limit increasing to £15,000 for the 2014/15 tax year, savers have a better chance than ever before of amassing a sizeable pot when the time comes to retire. However, many active funds – those that aim to outperform a benchmark through the expertise of a fund manager – levy high fees which can erode long-term returns. On a cost basis, passive funds offer an attractive alternative for investors searching for something to do with their extra £3,120 a year. The question is, is the lower price tag worth it?
Cheap as chips? Passive funds are inexpensive because managers only need to change their allocations when the index itself changes. Active managers invest in research and trade more regularly, incurring higher costs which are passed on to the investor.
to take into account. This je ne sais quoi enables one manager to beat the market, his peers and also charge a higher price into the bargain. Pinning down what alpha – or added value – is worth is tricky at the best of times. But if a manager underperforms for an extended period, its value is questionable. The price differential between active and passive funds was once 1 per cent or more, but price is no longer a topic for debate as far as Ben Yearsley, head of investment research at Charles Stanley Direct, is concerned. “Most active funds come in at 0.75 per cent now, while passives are 0.1 per cent to 0.25 per cent in general,” he says.
There is also the – sometimes elusive – manager skill
28
“This has fallen over the last 12 to 18 months in favour of the actives and so the difference is roughly 0.5 per cent.”
While 0.5 per cent to 1 per cent doesn’t look like a major stumbling block for active funds provided they can justify additional fees with outperformance, charges remain relevant, says Justin Modray, founder of ACTIVE FUNDS PASSIVE FUNDS candidmoney.com: 0.5% 0.1 % to 0.25% “Since the majority of active fund managers consistently fail to beat their benchmark index, then the fact they also usually charge higher The fall is due to the advent fees than a passive fund simply of clean fees, which have rubs salt into investors’ wounds.” stripped out miscellaneous costs, principally those paid to Fees are also important for investment platforms. comparing passive funds – some funds track the same index but “Previously there was not a level charge very different fees and playing field,” says Yearsley, “there’s no point paying over the “because trackers didn’t pay odds,” adds Modray. commission, whereas actives did and therefore you ended up paying the additional fee. At least Be prepared now everybody is in the same Building an ISA with passives is boat.” a straightforward process if you But Petronella West, director follow a few simple rules. of private clients at Investment Quorum, says the difference is Most returns don’t come from around 1 per cent on the funds picking the right fund managers, her clients use. but getting the asset allocation correct. This will be determined “The difference is 1.06 per cent, by investors’ objectives, be which is £160 a year on a £15,000 it capital protection, capital ISA, so you need to achieve that growth, a balanced portfolio, or level of outperformance to justify income generation. using active funds.” These factors will be determined West adds that on the by age – a young person may whole, lower cost funds have decide to take a few more risks outperformed their active than a pensioner seeking a secure counterparts over the last income stream – and also by the decade. type of investor you are. But, she highlights, this use of Many investors assume they historical data can be dangerous have an average risk attitude, if a favourable timeframe is broadly defined as how they selected for comparison.
0.75%
CASE STUDY BUILDING AN ISA FROM SCRATCH 1. What are your objectives? If you want growth, cash is no good, but if you want income, super risky or illiquid instruments will simply not do. 2. Decide on your asset allocation – how much in the UK and which assets, regions and sectors? 3. Go and find the most suitable funds based upon your criteria. 4. Do your homework, make your decisions and then leave it alone. Remember, these passive funds are not going to shoot the lights out. Behaving like a day-trader is more likely to destroy value than increase returns. 5. If you’re going passive, you may as well start with the cheapest funds and see how they perform over time. Monitoring performance is far easier with passive funds. 6. Keep it simple. Don’t have 10 funds if two will do, especially in the early days. react to investment uncertainty. Unfortunately, this is an assumption not often challenged until something goes wrong. Far more useful is an understanding of risk tolerance, a measure that is more instinctive and is essentially hard wired into an individual’s personality. You can get a free risk tolerance test (in exchange for your generic data) from Finametrica, which produces the test for the financial services industry, at https:// www.riskprofiling.coyour_risk_ tolerance. 29
Neil Parry of Black Knight Investment Data Services says that after determining asset allocation, fund choice should then be based upon sector. “The aim is to get the best fund or funds, whether passive or active. If for some reason an investor only wants passive funds, they should follow the same process of choosing the sector, then selecting the best passive funds in that sector,” he advises. Certain asset types do not lend themselves to being tracked, such as bricks and mortar commercial property or absolute return investments. Passiveonly investors therefore need to consider whether they need to compensate for these asset classes being excluded, perhaps by adding active funds to strike a better balance. Modray argues investors should diversify their investments as much as possible: “Given future performance is nigh-on impossible to predict, investors would be more sensible to focus on combining uncorrelated asset types to improve their chances of consistent returns and reduce their reliance on stock markets.”
The risk of deviation from the benchmark it tracks may be lower than with active funds, but this doesn’t make passive investments low risk. Passives can lose money and give an investor just as bumpy a ride. There are currently few passive funds available to minimise volatility, beyond a few low volatility exchange traded funds (ETFs). This makes spreading risk around a little more important, which means choosing uncorrelated – or less closely correlated – assets where they may be found. However, investors also need to demonstrate a degree of patience and pragmatism. “Performance is intrinsically linked to time horizons. All things being
equal, your passive portfolio should do better, but you must set realistic benchmarks and realistic timeframes and, in my opinion, every portfolio should be compared with cash plus inflation over a rolling five-year period, once fees have been taken out. That should be the ultimate benchmark,” says West. Finally, avoid tinkering with your ISA. This is a long-term investment, not a share portfolio, and doesn’t need to be checked on a weekly basis. Give it six months, then decide if things aren’t moving in the right direction. Building the most efficient portfolio is not about having passive or active funds in your portfolio, adds Parry: “It’s about having the best funds in your portfolio that cost the least.”
Diversifying a portfolio of £15,000 is not easy, but the following offers an example of how it may be achieved. Vanguard FTSE UK Equity Index
20%
HSBC FTSE 250
10%
Performance expectations
Vanguard FTSE Developed World ex UK
20%
Don’t expect a passive portfolio to outperform the benchmark after fees are deducted. A tracker fund that outperforms the index should ring alarm bells. This may indicate something going wrong with the manager or that the fund is riskier than previously imagined. Either way, it may not be what the investor originally signed up for.
Blackrock Emerging Markets Tracker
5%
Blackrock Global Property Equity Tracker
11%
Vanguard UK Investment Grade Bond Index
12%
iShares Global High Yield Corp Bond ETF Hedged
12%
ETFS PhysicalGold
10%
30
Witan wisdom
TM
“Money frees you from doing things you dislike. Since I dislike doing nearly everything, money is handy.”
Groucho Marx (1890-1977)
Make the most of your savings by investing in an ISA. The benefits of ISAs are fairly well-known but you may wonder why should you consider Witan for your stocks and shares ISA. Witan Investment Trust offers diversified exposure to global markets using a multimanager approach. Our global portfolio offers exposure to the world’s major equity markets thereby offering diversification by geographical region, industrial sector and individual stock. We are the only global equity multi-managed investment trust, which means in addition to striving to deliver added value we seek to smooth out the volatility normally associated with a single manager. Contact us to find out more about the Witan Wisdom ISA.
Witan Investment Trust is an equity investment. Please remember that past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise, as a result of currency and market fluctuations, and you may not get back the amount originally invested. For further information, simply scan or take a picture of the QR code using your Smartphone. It couldn’t be easier!
Witan wisdom ISA TM
Visit www.witanwisdom.com
Call 0800 082 81 80
Issued and approved by Witan Investment Services Limited. Witan Investment Services Limited is registered in England no. 5272533 of 14 Queen Anne’s Gate, London SW1H 9AA. Witan Investment Services Limited provides investment products and services and is authorised and regulated by the Financial Conduct Authority. Calls may be recorded for our mutual protection and to improve customer service. 31
TRUSTNET DIRECT PORTFOLIO MANAGEMENT
Exotic allure Investazine reveals the high-growth areas of the world you can only access through passive funds
DANIEL LANYON
The debate over whether active funds can outperform their passive rivals (or vice versa) over the longer term is set to rage for as long as both sides continue to periodically prove and disprove each other’s arguments. The truth in this decades-long tiff is the same as any ongoing skirmish: the answer is grey, not black or white. However, there is an argument that supersedes these two main and well-trodden deliberations. Passives can sometimes offer exposure to obscure – some may even say exotic – places or asset classes that are harder to reach when investing in an active strategy. Martin Bamford, chartered financial planner at Informed Choice, has bought an exchange traded fund (ETF) for his own pension. Exchange traded funds can invest in commodities as distinct as platinum, wheat or pork bellies, and are sold in a similar way to shares. Bamford bought an ETF that he says plays on the theme of global population growth and what this will mean for food producers. The iShares MSCI Global Agriculture Producers ETF seeks to track the performance of global companies primarily engaged in the business of agriculture. 32
With the global population currently growing by 75 million people a year and expected to total 10 billion before the end of the century, there will be many more mouths to feed as the years go by. Bamford hopes this will boost the value of this passive product by the time he retires and draws his pension.
which are collectively known as commodity currencies. Ben Stoves, investment analyst at Rowing Dartington, says that the passives he recommends tend to be for exposure to areas such as physical gold assets, for which he uses the ETF Securities Physical Gold tracker.
One of the key risks with this product, as with many globally focused investments, is that a movement in the value of a currency against the pound could unduly lessen the return, despite an appreciation in the value of the underlying asset.
The basket comprises the Australian dollar, the New Zealand dollar, the Norwegian Kroner and the Canadian dollar,
Both Nigeria and Brazil have been touted as among the front runners for economic growth over the next decade, thanks to commodity wealth, young populations and improving institutions. However, both countries’ stock markets have been subject to significant volatility, putting investors at risk of prolonged losses, especially on a shorter investment horizon.
Anyone looking for a different type of commodity exposure that mitigates some currency risk could also opt for the ETF Securities Commodity Currency Basket. This ETF mirrors a basket of currencies that reflects the performance of economies heavily reliant on the export of commodity assets.
Smaller Cap ETFs or the Global X MSCI NIGERIA ETF, although the latter is only currently available to buy in the US.
Anyone wishing to take a bet that the value of a particular stock market in a high growth country will increase from its current level could buy a passive emerging markets fund such as the iShares MSCI Brazil, MSCI Brazilian
Emerging markets are often cited as an area where active funds can add value because companies are numerous and under-researched, while their wide geographical spread makes information harder to access. Mike Deverell, investment manager at Equilibrium, holds the Vanguard Emerging Markets Stock index fund for wider exposure to this asset class.
33
He says that while research shows the average active fund is roughly equal in returns to the index, the consistency of these funds in equalling or beating the benchmark is lower than for other sectors. “For example, in some sectors a first-quartile fund in one calendar year had more than a 50 per cent chance of being in the top half of funds in the following calendar year. In some sectors this lasted for five years or more,” he said.
and ETFs tend to work best in liquid, well traded markets, which niche investments by definition are less likely to be. “I think exposing investors to niche areas or asset classes with trackers would come with the risk of a large tracking error or big counterparty risks, if synthetic tracking was used rather than full
Bamford also says commodity exposure tends to already exist indirectly in equity allocations (around one-third of the FTSE 100, for example, is made up of commodity and energy stocks) and gold ETFs often track the daily change in the spot price, so do not give an accurate reflection of the long-term price movements of the asset.
“In emerging markets, we found low levels of persistency. A topquartile fund had a greater-thanaverage chance of being in the bottom 50 per cent of funds just three years later.” “As the average active fund was only roughly in line with the emerging markets index, and as the research showed it was statistically difficult to find a consistently above-average fund, the obvious conclusion was to go passive.”
A word of caution Bamford says that while the exotic can offer high returns, trackers
replication,” he said. This is when an ETF owns derivatives rather than physical assets, which means that should the company go bust, the assets would not be ring-fenced for investors.
Investors should always beware of duplicating exposure when trying to increase diversification in their portfolios.
34
ANALYSIS
HOLLY THOMAS
And the beta goes on
What is “smart beta” and how can it help your portfolio? 35
Smart beta funds are probably not at the top of your shopping list as a DIY investor – some savers may never have heard of the term. But they may be worth investigating for anyone torn between active and passive investing. Simply put, smart beta refers to a style of fund that is a halfway house between the two, bringing together the skill of active investment – where a manager and research team select the best stocks they can find – and a passive fund that is run by a computer, tracking an index. For smart beta funds, the rules behind trackers are broken by only including stocks that fit the bill according to certain criteria. The argument is that traditional tracker funds that choose stocks based on the value of the business, otherwise known as its market capitalisation, will naturally have lots of expensive stocks and fewer cheaper ones. Advocates of active management claim this is not the best approach because it is often those cheaper stocks whose share prices have the biggest headroom to grow. Here’s what you need to know about smart beta
How do they work? Smart beta funds hope to beat the market in the same way as a skilled active fund manager, by being programmed only to hold stocks that match certain criteria and that target a specific area. One strategy for smart passive
funds is to target stocks paying high dividends. Typically, a passive fund would invest according to the value of companies in an index, but income exchange traded funds (ETFs), a type of passive fund, use the levels of dividend payouts to choose stocks.
“By being more selective about which stocks they hold, smart beta funds aim to outperform ordinary passive funds. “
Alternatively, they can choose to target cheap stocks by having a heavier weighting to those companies overlooked by the market, which have a good chance of rising in price over time. Others will hunt stocks based on their levels of volatility – targeting more stable ones – the size of the company, or perhaps earnings growth. By being more selective about which stocks they hold, they aim to outperform ordinary passive funds.
How can investors use smart beta in their portfolios? These funds are not a mainstream type of investment and as such are not particularly easy to research. Organisations such as the Investment Management Association do not currently provide a sector classification that allows investors to make easy comparisons with other similar funds. There are a number of smart beta funds to choose from today. DIY investors can access them on
fund supermarkets or through their financial adviser or wealth manager. Philip Bailey, an investment consultant at wealth manager Proviso Chartered Financial Planners, recommends the First Trust AlphaDEX range. He says: “These funds work really well and offer exposure to the UK, emerging markets and the US. The VT Maven Smart Dividend UK fund, which weights companies based on their dividend payout, is interesting. If they do not pay a dividend, they do not go in the fund.” There is also the iShares FTSE UK Dividend Plus (IUKD), which aims to track the performance of the 50 highest-yielding stocks in the FTSE 350 index, excluding investment trusts. Alternatively there is a fund from Vanguard – a huge advocate of passive investing – called the UK Equity Income Index. Other organisations have shown interest recently. In August, the National Employment Savings Trust (Nest) – an automatic enrolment workplace pension scheme – adjusted its strategy to invest more of its members’ money in smart beta. In a bid to improve gains for the billions of pounds of retirement savings, Mark Fawcett, chief executive of Nest, said he 36
was interested in “alternative indexing”, or in other words, smart beta. He said: “This is in recognition of growing evidence that alternative indexing can be a good way to capture these opportunities while still keeping costs low.”
Cost of investing One of the main reasons why investors use trackers is because they are usually cheaper than paying a manager, particularly as so many of them fail to beat the wider market. Supporters of smart beta believe their approach can provide active returns with passive prices. While there is a degree of active management in smart beta funds, fees can still be low because a computer will do most of the work. A typical active fund today will cost around 1 per cent a year to run, compared with as little as 0.1 per cent for a passive fund. Smart beta funds cost around 0.5 per cent a year.
What’s the verdict? Bailey recommends smart beta funds to his clients, saying: “They offer a predictable performance which suits our approach for clients. But smart beta won’t take over the world. Even in the US where they are far more established, they only represent 3 to 4 per cent of their market.” “Most UK advisers don’t look at these funds, instead staying loyal to mutual funds, because that’s what they’re used to. It’s
not something DIY investors would come across easily either. But it’s something that works well for us.”
“This is in recognition of growing evidence that alternative indexing can be a good way to capture these opportunities while still keeping costs low.”
Peter Sleep, wealth adviser at senior investment manager Seven Investment Management, says: “Applying intelligence to tracker funds adds value by enabling investors to access the best of an index without paying for an active manager.”
However, Hannah Edwards at BRI Wealth Management is less enthusiastic: “Research suggests that money in this asset class has increased five-fold since 2010 as investors lose patience with active management underperformance from a lot of fund managers.” “At BRI we don’t currently use smart beta funds because we are confident that our active managers have robust investment processes and will continue to generate outperformance over the longer term.” “However, if we do look to gain quasi-passive exposure to a market, then we will definitely consider smart beta funds.” There are still risks with passive investments. If the market falls, your investment is going to fall, whereas a manager should be able to protect your money more effectively against these downsides.
Mark Fawcett, NEST and typically costs more than passive investments and so it will be interesting to see if it really catches on in the retail world. I’m sure there will be periods of popularity as certain strategies produce strong short-term performance figures. However, we don’t currently use smart beta with our clients.” “We’re always wary of specialist investments and so don’t typically use – for example – technology funds, healthcare funds, financials and specialist country funds such as China.” “Smart beta funds are likely to put investors overweight in a particular sector or type of stock and we’re not yet convinced that they will necessarily outperform. You probably need to get your timing right in and out of different characteristics and styles – whereas we do long-term asset allocation rather than trying to time markets.” Perhaps this is a case of “watch this space” for investors who may want to see a longer track record from these funds to judge how they perform across different market cycles.
Patrick Connolly at Chase de Vere is not yet sold on the idea of smart beta. He says: “The reality is that the approach isn’t active
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ANALYSIS
Follow the leader When a star manager quits, should investors follow him, or trust the investment house to install a worthy replacement? IONA BAIN
MAN versus MACHINE
In 1997, IBM’s Deep Blue became the first computer to beat a chess world champion. Now computers can manage your money too. They set up index or tracker funds to buy all the shares in an index, say the FTSE-100, and replicate its performance. The passive approach cuts out a highly paid manager and a back-up team of analysts. But fund houses want investors to believe that their active funds can beat computers by cherry-picking shares and sectors. 38
When it comes to actively managed funds, investors in the UK are certainly not short of choice. There are a whopping 2,150 unit trusts and 400 investment trusts out there. So how do you pick the best long-term performers? After all, seven out of 10 managers don’t do any better than index funds picked and managed by a computer. In fact, many of them do far worse. But some active managers beat that benchmark year in, year out, and enjoy legendary status as a money manager as a result. This year saw equity income king Neil Woodford abandon £21bn in his High Income and Income funds at Invesco Perpetual to set up his own CF Woodford Equity Income fund, and the Pied Piper effect has already sucked in £2.1bn behind him. Research by Aegon has shown that funds that have lost a star manager in the past have consistently failed to recapture old glories, even if they have performed respectably against their chosen benchmark. Out of 11 sizeable funds where the manager has changed in the past decade, only two have seen the new manager match the old one.
Riding on a reputation Many investors wonder whether there is a convincing succession plan at fund houses that appear to rely on the stellar reputation of one or two managers. Take Fundsmith Equity for example, run by the muchrespected Terry Smith. In response to Investazine’s questions about a succession plan, the firm replied: “It is a partnership and the partners,
including Terry, cannot sell their stake, or a part of it, to an outside third party. If Terry is not around for unplanned reasons, Fundsmith’s head of research Julian Robins, who Terry has worked with for 28 years, will take over as chief investment officer.” But Alan Steel, principal of Alan Steel Asset Management, notes that investment houses with star managers do not talk much about a plan B. “I think they should be a bit more vocal about it. You never meet the second in command until the leader actually departs.” Justin Modray at Candid Finance agrees: “The minute the manager leaves, massive teams of analysts and comanagers come out of the woodwork.”
More of the same? But staying put may make sense. Invesco Perpetual quickly moved to reassure investors that Mark Barnett, who had been managing the Invesco Perpetual UK Strategic Income fund, would take over from megastar Neil Woodford. After Richard Buxton stepped down from Schroders’ successful £1.7bn UK Alpha Plus fund, the
WARNING SIGNS One warning sign is a change to the fund’s structure, such as when Fidelity Special Situations was split in 2006. Hollands says: “The global version was initially managed by little known manager Jorma Korhonen from September 2006 to December 2011. Performance was disastrous and Korhonen has left Fidelity.” More alarming is the departure of an entire team, as when Threadneedle’s US desk decamped to Artemis. Steel says: “When something like that happens, we put funds on an orange or red warning, and this would have been red – when a whole desk leaves, that is a dangerous sign.” Threadneedle has made an internal promotion, and Hargreaves Lansdown says investors “should proceed with caution”.
firm’s solution was to raid Jupiter to hire the well-regarded Philip Matthews. On both counts, the successors had perfectly good credentials in their own right. Research by FE Trustnet found Barnett’s own track record since 2007 correlates very closely with Woodford’s outstanding figures. Conversely, the promotion of an unknown manager could be legitimate cause for concern. Gavin Haynes, managing director of Whitechurch Securities, says: “When Graham French, the long39
standing manager at M&G Global Basics, was replaced, we stopped recommending this fund as the new manager, Randeep Somel, was in our opinion unproven.” The Aegon research found that the relatively unknown Sanjeev Shah and Alex Wright on Fidelity Special Situations have beaten their performance benchmark by 1.9 per cent a year since 2008 – a perfectly decent showing following their promotion to the top job. However, the previous manager – fund legend Anthony Bolton – achieved a far better 5.3 per cent per annum outperformance over the preceding 23 years. Regarding the Schroder UK Alpha Plus fund, previously run by Buxton, Bestinvest’s Jason Hollands cautions: “Philip Matthews’ numbers at Jupiter, where he managed the Special Situations fund, were very good. However, that alone isn’t a guarantee of success at another firm if the culture and resources are very different, or the size of assets handed to the new manager are much larger than they can cope with.” Haynes says: “Matthews came into the fund with a more conservative approach, subjecting it to a major overhaul that presents quite a different proposition for investors.”
Keep calm and carry on “The key issue is whether the fund will continue to be managed in the same style or with the same process. If a strong internal
candidate cannot be promoted, the chances are the fund house will try to recruit someone with a similar style of managing, and if you jump ship, you may not get something that is the same,” Modray says. Indeed, a successful fund that is genuinely aiming for the greatest degree of continuity possible presents positive omens for investors. Following the death of UK smaller companies specialist John McClure in June, Unicorn Asset Management stressed his “team-based investment approach”. “In this case we feel that the fund is in safe hands as the ‘new’ managers Simon Moon and Fraser Mackersie have worked closely with John since 2008 and were already integrally involved with the fund,” Hollands says. At Invesco, Mark Barnett represented continuity and a track record. Alan Steel says: “Our conclusion was this man (Barnett) suits us fine because he is boring, just like Neil Woodford. You have to remember that, for 17 years, he was the guy sat behind Woodford.” But a high-profile managerial departure may give a fund a
much-needed shot in the arm. Weak performance led to Martin Gray quitting niche manager Miton Asset Management in June. He was previously a star performer for 15 years but recently lost money for investors in a strong market. In such a situation, the investment house stresses not continuity, but change. On his arrival at Miton in June, successor David Jane listed half a dozen changes he had already made to the portfolio across equities, property and bonds, aimed at persuading investors to stay put. Modray urges investors not to make snap judgements. “When a manager leaves, the fund won’t crumble overnight. Similarly, it is rare that someone will turn a fund on its head or change things in the space of few days or a week; it could take months or even years to see changes.” The trust is on a discount of just over 10 per cent at present, which Lovett-Turner says allows investors to get exposure to a quality manager at a fair price – especially if you are optimistic that emerging markets are due a stronger period of performance.
ANOTHER WAY TO GO? Alternative funds, rather than following the Pied Piper, will often be the advisers’ choice. Wellian Investment Solutions, for example, dumped Woodford’s Invesco Perpetual funds and the Unicorn Income fund in favour of Threadneedle UK Equity Income, Rathbone Income and Psigma Income. For US exposure, Alan Steel Asset Management is looking to Neptune. For smaller companies expertise, Tilney Bestinvest has been impressed with Ardevora, new home of former Liontrust star Jeremy Lang.
40
ANALYSIS
MONA SHAH RESEARCH ANALYST, RATHBONE UNIT TRUST MANAGEMENT.
It takes two to tango How to use active and passive funds together
Both active and passive styles of investing can co-exist in a portfolio. Active equity investment aims to outperform a given equity benchmark, while passive tries to mirror its risk and return profile. Our portfolios have an active bias, but we do think that passive strategies can
be helpful in reducing risk as part of overall efficient portfolio management. We believe that the best way to think about them is that passives are a tool, not a solution. For example, they can be used for tactical purposes during times
of high volatility in the market. At this juncture, fundamentals are being rewarded. Our focus is therefore on alpha, or adding value, and index-agnostic managers – those who don’t tie themselves to a specific index or benchmark.
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Passives: for better or for worse? Theoretically speaking, there are certain asset classes that lend themselves better to passive investments: these are markets that are considered to be more efficient and where active managers may struggle to add value. These include the US and, to some extent, the UK, which are liquid and well researched markets. However, when markets start to look expensive and opportunities are harder to find, investors may want to switch to active managers. Also generally speaking, small cap stocks and other assets that are less liquid or considered riskier are better suited to active managers. For example, emerging markets and Asia are two sectors where stockpickers can really add value. Investors may also find that the indices in these areas are heavily weighted towards one sector, so they lose diversification benefits (Brazil’s index, the Bovespa, springs to mind. The index is heavily weighted towards mining). There are also illiquid asset classes such as property, infrastructure and even fixed income – sectors which are all very affected by flows – that we believe are also better suited to active management.
be broad-based (sector-wise) or not. If it is, then it may be an idea to buy passive, to capture that upside in the first instance. However, if earnings growth is only taking place in select areas, or most of the market is looking overvalued, then passives are likely to underperform and active management may be a better option. If you can take stock-specific risk and have a longer time horizon, then a more concentrated fund can offer a better option, although individual sensitivity to costs, underperformance and benchmark risk are also important considerations. In addition, if investors believe that markets are likely to be very volatile for some time, they may wish to use those dips to add to passive exposure. Passives can offer more visibility in this respect – investors know exactly which level they are buying the market at (or taking-profits, for that matter). Needless to say, with an open-ended fund, (for example, one that is priced daily), we do not enjoy the same level of visibility when it comes to the price of the underlying assets. Passives can help investors not only be more tactical in their decision-making, but also support performance if markets go through uncertain times. This year provides a prime example, following months of volatility. Since the start of the year, the FTSE 100 has performed strongly, whereas a number of very good active managers have underperformed. So, notwithstanding the associated trading costs, a
Year-to-date performance of FTSE 100 5%
A
4% 3% 2% 1% 0% -1% -2% -3% -4%
What time is the “right” time? Active and passive investing can provide different benefits given different market conditions. In terms of allocating, a key question for investors is whether they believe that alpha-generation will
-5% Jan 14
A – FTSE 100 (4.5%) Sep 01 January 2014 – 05 September 2014 © Powered by data from FE 2014
Source: Trustnet Direct
key plus-point for passives is that they can reduce the risk of underperformance quite meaningfully, albeit in the short term. So keep your eye on the ball when things change!
42
How to measure performance In terms of the measurement of performance when it comes to passives, it is possible that some funds may fail to beat the index because of the costs incurred. But more often than not, investors measure performance by using
tracking error – the difference in returns of the passive vehicle versus the returns of the benchmark that the investor is tracking. Some passive vehicles are involved in stock lending, the temporary loaning of securities to a third party. That revenue should come back into the fund, which may offset the costs of the trading, which in turn may support performance. But all passives are not equal and there are some key assumptions and considerations for investors.
•
•
Not all passive strategies track 1:1 and it’s important that investors are aware of the specifics with regard to what is being tracked. More recent launches have attempted to weight stocks equally or have focused on other factors such as valuations, cashflow or yield. These vehicles are semiactive at best.
We are also concerned about the interest in fixed income ETFs (exchange traded funds). Investing in fixed income ETFs may appear to be simpler than equity ETFs; however, on
further investigation, they are significantly more complex because of the fluctuating liquidity environment. Fixed income indices give larger weightings to the most indebted companies. The lack of liquidity and lack of a central exchange create greater challenges when tracking non-government
bond indices. Fixed income ETFs can also suffer from the classic herding effect, which results in a discrepancy between the price of the ETF in the market and its net asset value – this spread can be quite wide. We still think that active managers are better placed to manage fluctuating liquidity conditions in fixed income markets.
•
We are also sceptical about commodity ETFs, owing to the problem of the “negative roll yield” when investing in commodity futures. This is because the curves tend to be in contango – when the price of a futures contract is trading above the expected spot price (the price at the time of trading) when the contract matures – eating into investor returns and making the returns less predictable. This is especially important to remember if you intend to hold contracts over the longterm.
Our strategy One of our central views at the start of the year was that stock dispersion would be high, meaning there would be a wide range of values among stocks in the market – we continue to adhere to this, and are therefore running an active bias in the portfolio.
Our most active positions are in the US, for a number of reasons: we are positive on US GDP growth, but markets are looking expensive there and opportunities are harder to find. We are therefore buying very active funds which target stocks that have superior earnings growth within this kind of market, or stocks that are trading on a valuation discount, thus offering a margin of safety. One of our preferred funds is Edgewood US Select Growth. This is a concentrated fund of around 20 stocks, which is also overweight tech and healthcare. On the value side, we also like Dodge & Cox US Value, which is still trading more cheaply than the rest of the US market. In our most defensive portfolio, we bought the iShares FTSE 100 in March on a dip and sold in July close to the peak. This is because we switched into active managers where we had greater conviction, given the market is flirting with all-time highs.
43
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ANALYSIS
Leaving the past behind How to pick a good active manager without looking at past performance JOSHUA AUSDEN
I’ve lost count of the number of times I’ve read an article or research paper that has declared “past performance is not a guide to the future”, only for the author to present a raft of performance data to speak kindly of a fund or fund manager. I should know – I’ve done it myself on countless occasions.
What a fund manager has done in the past in no way guarantees that they will perform similarly in the future, but there’s very little else for investors to draw upon. I suppose it’s rather like buying a second hand car that has never broken down before – the wheels could well fall off (literally), but it’s reassuring to know that it has a solid track record.
45
I would personally argue that past performance can be useful, not least because it proves that a manager has been there and done that through an entire market cycle. Experience is a big plus in most walks of life and fund management is no exception. How funds have performed in certain market environments can also be useful – the likes of Neil Woodford, Troy’s Sebastian Lyon and First State’s Angus Tulloch have a keen eye on downside protection and prefer stocks that tend to hold up better when markets fall. This is not guaranteed of course, but a guide to the future? Others would disagree, but I would say so. If the markets crash 50 per cent tomorrow, it would be a brave man to bet against Woodford losing less than the FTSE All Share. Nevertheless, Hawksmoor’s Daniel Lockyer says there are certain attributes that help investors identify the managers that best fit their objectives that have little or nothing to do with past performance. Lockyer, a fund of funds manager who runs the £30m PFS Hawksmoor Distribution portfolio, says that first and foremost having a clear mandate and philosophy is the key to being a good fund manager. “You’ve got to know what you’re getting – not from a performance point of view every year, but from how they behave,” he said. “If the fund says it will be high beta, it needs to run away with markets, and if it says it’s low beta, it needs to do something different.” He highlights equity funds run by Baillie Gifford as a good example. Managers such as the Scottish Mortgage Investment Trust’s James Anderson and Baillie Gifford Global Discovery’s Douglas Brodie identify long-term trends that they think will deliver over a five-year period at the very least. While they are susceptible to periods of short-term pain, they stick to their guns and the results speak for themselves. “Baillie Gifford is certainly not for everyone, but you know what you’re getting,” said Lockyer. “They persevere, and that’s the important thing. They are very clear in how they run money and even through the bad times don’t change their process.”
Lockyer says perseverance and patience are very important attributes, as many managers claim they do one thing but lose their nerve when things get tough. “If you’re investing in a manager because you feel that value stocks are going to outperform, and then the manager who says he is value-orientated suddenly starts investing in growth stocks, then it can be very frustrating,” he said. “It’s about how managers react in the bad times as well as the good times.” Humility, Lockyer says, is extremely important. He is wary of investors who are overly confident and assume they will be able to outperform year after year. “You’ve got to be able to acknowledge that you’re not always going to be right,” he said. “You can’t outperform every year.” That’s not to say confidence is not a good attribute in a fund manager, of course. Lockyer says that the very best managers are those who “live and breathe” investing and have the conviction to back their best ideas – especially when it comes to their own money. “There’s a big difference between a benchmark-plus fund and one that the manager really, really believes in,” he said. “I like to look out for the managers who buy their own shares. The amount of money a manager has in their own fund is very important and is a good indication that they believe in what they are doing, and that their interests are aligned with the investor’s.” “You can talk the talk, but when you have your own money invested you know that what you’re doing is genuine rather than on the behalf of a marketing department.”
In a previous article on FE Trustnet, we looked at the managers who put their money where their mouth is and bought substantial stakes in their own funds.
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He says he likes managers who acknowledge their mistakes and talk down the prospects of their chosen asset class. He is wary of the ones who are constantly ultra-bullish, because it implies that they are more interested in selling units of their fund rather than giving a true picture of what they expect. Lockyer points to a recent note from manager of the Lazard Active Global Listed Infrastructure Equity fund Bertrand Cliquet. “The current opportunity set of attractively priced investments for the strategy is smaller today than it has been over the past five years,” said Cliquet. “Investors should not expect the strategy to deliver the same level of outperformance as it has been able to achieve in recent times.” In reaction to this, Lockyer said: “This is a fund we own in the Distribution fund that has done a great job over the past 12 months and will be maintained despite the lower expectations.”
McGlashan is always bullish on Japan, but we’ve got to know the scale of his bullishness. If he’s seven out of 10 on the bullishness scale, we know he’s not all that optimistic.” he added. Among the other managers who have talked down the fortunes of their asset class are Mark Barnett, manager of the Invesco Perpetual High Income fund, who expects UK equities to have a tough time compared with their stellar gains since the financial crisis. FE Alpha Manager Harry Nimmo recently said that he expects his Standard Life UK Smaller Companies fund to make half as much over the next five years as it did over the last five. Lockyer says that listening to the outlook for asset classes from investment trust managers is particularly useful, because of their closed-ended structure. “They are not rewarded by fund sales and therefore tend to be more honest in their commentary,” he said.
“There are certain managers who are always bullish. [Manager of the JOHCM Japan fund] Scott
/ www.feanalytics.com
CELEBRATING 10 YEARS 47
COMMENTARY
The
The passive paradox
The Active vs Passive Debate
PART
1
SIMON EVAN-COOK SENIOR INVESTMENT MANAGER AT PREMIER MULTI-ASSET FUNDS
From what I gather, the passive argument has two basic prongs. The first demonstrates that the average active manager underperforms the market. I could pick nits with this argument, but it’s basically fair: if you assume that active managers collectively make up the market, it is clear that the average one will achieve market performance less any charges.
It would be petty to dispute the spirit of this point: I work hard to avoid investing with average fund managers myself, so I can hardly suggest others put
up with them. But passivists don’t leave it there, hence their second prong – everybody is average. Here they claim that all active fund managers fail to beat the market. Or that even if a few do manage this feat, it’s impossible to identify them in advance. Therefore, we should all give up and go passive. This, in contrast to their first point, is guff. Many managers do beat the market. Warren Buffett, Anthony Bolton and Neil Woodford are famous examples, but there are plenty more who’ve done so over meaningful periods. However, quant-heavy 48
Active vs Passive E BATE D
studies knock many of these out on the exceptional – but short-lived – periods when they have lagged behind the market. To this I say, if a manager averages 5 per cent a year more than his market over the decade I’m invested, I don’t care if one particular calendar year was marginally sub-par. Even when passive researchers do begrudgingly acknowledge such managers exist, they are busy “proving” it’s impossible to pick them in advance. In one recent paper, the author asked himself “can I pick a winning portfolio in advance?” To which the answer was “no”. This was no shock – partly because he worked for a passive provider, but mostly because his only attempt at picking a winning portfolio relied solely on past performance data. Well, I could have saved him the bother: using past performance at the exclusion of any other factor is a disastrous way to pick a fund. It is the calibre of blinkers-on decisionmaking that, at the instruction of a satnav, drives a car straight into a river.
Just as avoiding the Severn in full flow is obvious to any sensible driver, many simple factors that are self-evident to humans are discounted by quantonly studies (such as talented managers leaving one fund for another). They also frequently cover periods that are arbitrarily picked (at best). Another recent paper made the startling discovery that funds that had outperformed in the savage sell-off of 2008 to 2009 generally failed to outperform in the raging bull market that followed. Really? You’ve spent too much time with your data if you were shocked by that particular outcome. The fact is, passives do serve a purpose. For investors honest enough to admit they lack the time, interest or knowledge to pick a good active fund (and the patience to stick with it), trackers make sense. But to suggest it is impossible for a fund manager to outperform, and that common sense cannot be used to identify such a manager, is simply not true.
49
The Active vs Passive Debate
A passion for passives
PART
2
SHAUN PORT CHIEF INVESTMENT OFFICER OF NUTMEG
At Nutmeg, we’re big advocates of asset allocation and the use of passive funds to spread risk and reward. We believe it is easier to target reliable long-term returns and spread risk if you favour investing in passive funds, which track an index such as the FTSE 100 or S&P 500, an asset class such as government bonds, a market segment, a region or a sector. There is a lot of evidence and research to support the theory that active fund managers who pick individual stocks and bonds generally fail to consistently beat the market. Similarly, Determinants of Portfolio Performance, the seminal 1986 study by Brinson, Hood and Beebower which entrenched industry views about the importance of asset allocation over stock selection, showed that 93 per cent of the variability of pension fund returns were due to asset allocation – that is to say the mix of different investment assets that constituted a portfolio – rather than the actual stocks within it. More recently, in 2010 Roger Ibbotson published The Importance of Asset Allocation in the Financial Analysts Journal, which delved deeper into explaining the significance of asset market volatility overall rather than differences in investment policy.
This provides support for Nutmeg’s active asset allocation strategy compared with fixed-weight policies used by many of its competitors. To be specific, we advocate a “managed approach/ passive funds” stance. While the funds we invest in are passive, our investment approach isn’t. We believe that a completely static approach to managing investments can be harmful. It’s important to regularly monitor and rebalance the asset allocation of a portfolio to make sure it contains the right balance of high- and low-risk assets, geographical exposures and industries to help keep it on track in terms of the client’s objectives. In particular, we favour investing in exchange traded funds (ETFs) as they provide an easy way to gain access to a large range of investments without having to buy each one individually. They also represent a low-cost way of gaining such broad investment exposure. We have found that ETFs are becoming even cheaper as they grow in popularity. There are now around 2,000 ETFs in Europe, which we distil into approximately 60 to 70 preferred funds covering each asset class, geography, industry sector and style – for example high dividend.
50
An ETF tracking a developed market can cost as little as 0.1 per cent a year, as opposed to 1.5 per cent or 2 per cent for an actively managed fund. This means we can pass the savings and performance directly on to our customers.
can charge per trade, which can quickly become expensive if you’re investing regularly in a very active manner. If that’s the case, it’s best to use a provider with large-scale access to these funds who will charge you a fixed fee.
ETFs are flexible too. They can be traded at any time, provided the stock exchange is open, unlike an actively managed fund, which trades at one set price point during the day.
Secondly, be sure that you are aware of the currency an ETF is traded in, since those traded in a different one can expose you to foreign exchange risk. The exchange rate fluctuations may affect the capital performance and income generated from these ETFs when converted to sterling.
There are a couple of things to be careful of when delving into the world of ETFs. Firstly, some ETFs
For example, we think the Japanese yen is likely to weaken even more against the pound after losing 14 per cent over the past 12 months, so we use the UBS MSCI Japan GBP hedged ETF – at an annual cost of 0.45 per cent – to invest in Japanese stocks.
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This document is aimed at Investment Professionals only. All content is intended as general information only and does not constitute advice, recommendation or investment research. This information is not guaranteed to be correct, complete, or accurate. FE Research is a division of Financial Express Ltd, an appointed representative of Trustnet Ltd which is authorised and regulated by the Financial Conduct Authority. For our full disclaimer please visit www.financialexpress.net/uk/disclaimer.
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The Active vs Passive Debate
Best of both worlds
PART
3
GAVIN HAYNES MANAGING DIRECTOR OF WHITECHURCH SECURITIES
Whether to take an active or passive approach is one of the longest-standing debates in the investment world and, in my view, one of the most futile. I don’t believe that there is a clearcut answer. Both index-tracking, passive funds and taking the active approach through paying fund managers to try to beat the market have their merits. When building a portfolio, my starting point is to decide upon the required asset mix, based upon the risk/reward profile and the current investment climate. From this point I look at whether passive or active funds are better-suited to meeting my assetallocation requirements. First of all, I look at the passive options available. The reason behind this is that they provide the cheapest and most transparent access to market returns. I use these funds as my benchmark and if I am going to incur the extra cost of an active fund, then I have to have a reasonable degree of confidence that it is going to provide better risk-adjusted returns. I do get frustrated that advocates of passive investing can get blinkered with the view that the cheapest option is always the best. This is not true and to quote legendary investor Warren Buffett: “The price is what you pay, value is what you get.” If you invest in an actively managed fund that then beats the index after fees are taken into account and without taking on extra risk, this has obviously been the better option.
Close to 90 per cent of UK active equity fund managers beat the UK stock market last year, according to S&P Dow Jones indices. This is not always going to be the case, but in many global stock markets there are fund managers who have far outstripped long-term stock market returns. For more than a decade I have invested in Neil Woodford in the UK, Richard Pease in Europe and Angus Tulloch in Asia, with exceptional results. However, there are investment markets where I would often prefer a passive over an active fund. The US stock market is notoriously difficult to consistently outperform as it is so thoroughly researched. Therefore for core US exposure, a low-cost index fund should definitely be seriously considered. Away from equity markets, I use passive options for investing in government bonds. With yields so low, the effect of active management fees can have a big bearing on returns. Conversely, only using passive funds can narrow the diversification options. I currently favour direct exposure to commercial property, but there are no passive options that can match the risk/reward profile of active funds investing in bricks and mortar. I also use selective absolute return funds, the epitome of active management, which can offer attractive riskadjusted returns to a portfolio. I believe that you should be looking at both the passive and active fund options available when building a portfolio. In many cases an optimum portfolio will include a mix of both styles of investing. 52
COMMENTARY
Dividend Of The World
The best way to diversify your income stream is to invest outside the UK, according to Lowes Financial Management’s Paul Milburn. PAUL MILBURN Paul Milburn is an investment analyst at Lowes Financial Management
For those investors who wish to avoid the concentrated nature of investing for income via UK equities, sourcing dividends on a global perspective serves as an attractive alternative. The best way to achieve this is through actively managed funds with strong investment processes and clearly defined policies on dividend income capture. Investing for dividend income on a passive basis makes little sense as stock selection is driven by market capitalisation of stocks within the index, rather than the company’s dividend policy. So, from an income perspective, is investing in overseas equities attractive? Current average yields would suggest so. Looking at data from FE Analytics, the current average yield for the UK Equity Income sector is 4.01 per cent. The Global Equity Income sector meanwhile has a healthy yield of 3.51 per cent. There are no other equity income sectors provided by the IMA, but it is worth dissecting
the other equity sectors to identify equity income funds. For example, the average yield for funds in the IMA Europe ex UK sector with an income objective is 3.62 per cent, while doing the same for the Asia ex Japan sector gives an average yield of 4.45 per cent. A potential concern for investors is that by adopting a dividend strategy, they could miss out on investing in stocks with strong capital growth prospects. This could be of greater concern if you are of the opinion that the market will continue to rise from here. However, many fund managers, and indeed the investment team at Lowes, focus on total returns. This focus suits both those clients who wish to receive the income and also those who wish to reinvest it. Looking at the historical returns of the MSCI World index versus the MSCI World High Dividend index, it is evident that a dividend strategy could reward investors. From 2000 to 2013 inclusive, the MSCI World produced a total
return of 62.1 per cent. Over the same period, the MSCI World High Dividend Yield index produced a total return of 138.85 percent. Here at Lowes, we also pay close attention to how global higher income-producing stocks perform against global equity as a whole in different market conditions. Looking at calendar years to 2013, in all down markets since 2000, except in 2008 where many banks cut their dividends, MSCI High Dividend Yield outperformed MSCI World. A dividend strategy also tends to be more resilient in market downturns. Dividend-paying companies tend to be well managed, have strong balance sheets, free cash flow generation, visibility of earnings and barriers to entry in their market. This explains why investors feel more comfortable holding them when times are uncertain. In rising markets, it is usually better from a total return perspective to be invested in the
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Year
MSCI World
MSCI World High Dividend Yield
2014 YTD*
4.84%
6.62%
2013
27.37%
22.89%
2012
16.54%
13.30%
2011
-5.02%
4.84%
2010
12.34%
7.22%
2009
30.79%
33.75%
2008
-40.33%
-42.39%
2007
9.57%
7.34%
2006
20.65%
28.90%
2005
10.02%
8.50%
2004
15.25%
20.02%
2003
33.76%
30.51%
2002
-19.54%
-9.80%
2001
-16.52%
-8.03%
2000
-12.92%
1.53%
Source: MSCI, All returns in USD *to 31 July 2014 MSCI World index, rather than the MSCI World High Dividend Yield index. However, this is not necessarily always the case, as illustrated in 2004, 2006 and 2009, when the dividend index outperformed. One possible reason for this occurrence in 2009 was that investors made a flight to quality stocks for safety following the huge losses seen during the financial crisis. Quality stocks are typically those with the characteristics mentioned earlier and thus continued to pay dividends. No one knows for certain what direction the market is going to take, but looking at our analysis, the value in a dividend strategy is clear in its ability to be more resilient in down markets than a growth one, but can still outperform in rising markets. There are a variety of approaches that an active fund manager may adopt when investing for income from equities. They may invest in companies that have a high dividend yield, companies that have the potential to generate dividend growth, companies
with the potential to become dividend payers, and dividend “aristocrats”. This last group refers to those businesses that have consistently paid and increased their dividend over a sustained period of time. The classic example of this is Coca Cola, which has paid a quarterly dividend since 1920 and has increased its payout in each of the last 20 years. Managers often use more than one of these strategies in their portfolios. Some funds have target yields they expect to achieve, while others do not. Being active also provides the flexibility for the manager to adapt their strategy to the economic environment. One fund we favour that does exactly this is M&G Global Dividend. Here the manager is willing to sacrifice higher dividend-paying companies when stockpicking in a strong bull run in order to capture a decent level of capital growth. They clearly therefore demonstrate their understanding of the importance of total return when income investing. A further fund that we like is Lazard Global Equity Income. The managers of this fund are willing to deviate from their benchmark (the MSCI All Country World index) in terms of regional weighting, with stockpicking being the driver behind regional allocation. At the end of July, for example, 29.7 per cent was allocated to North America, compared with the benchmark’s 52.7 per cent, while it had a 22.3 per cent weighting to continental Europe compared with the benchmark’s 16 per cent. The fund is also willing to take exposure to sources of dividend income from emerging markets, an area of investing that Lazard has significant expertise in. Diversification is also visible at sector level and again is not constrained by benchmark allocations. Although the fund has a target gross yield of 5 per cent, it also focuses on longer-term capital growth. To do this it maintains a balance of defensive and cyclical stocks, so it can capture the upside in rising markets. As an investment adviser, we select fund managers that have proven expertise at delivering attractive returns over the long-term through stockpicking, and that aim to deliver an appealing level of income without losing sight of total return.
55
COMMENTARY
Access all areas Should investors look to investment trusts or ETFs for access to specialist investment sectors? JAMES GLOVER MANAGING DIRECTOR, JP MORGAN ASSET MANAGEMENT SPECIALIST POOLED FUNDS GROUP The earliest investment trusts were launched in the UK in the middle of the 19th century and, as one of them stated at the time, were designed “to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk of spreading the investment over a number of stocks”. Since 1868, the number of investment trusts in the UK has risen to nearly 400, providing exposure to equities, bonds, private equity, hedge funds and numerous other strategies. The first exchange traded fund (ETF) was launched in the US nearly 125 years later, in 1993, and was designed to produce comparable returns to the S&P 500. Almost every ETF launched in the following 15 years was in effect a tracker fund, aiming to replicate the returns of a given benchmark. The more recent explosion in popularity of ETFs has led to the
development of increasingly complex investment vehicles, such as active or fundamental ETFs; however, active ETFs are still in their infancy and it is still too early to tell how successful they will be in the years to come, both in achieving their aims and attracting investors’ capital. Both ETFs and investment trusts are quoted and traded on stock exchanges and have a broad diversity of investment strategies, so how do they differ? The main difference is their structure: investment trusts, which operate under company law, have a board of independent directors who have a fiduciary responsibility to act in the best interests of their investors. They are able to appoint a different investment manager if performance is not good enough, or to change the mandate should the existing mandate become obsolete. They are also permitted to borrow money to gear their
portfolios to further enhance returns, although this can also compound losses in falling markets. The structures of ETFs are enormously different to investment trusts. They trade on a stock exchange but do not have a board of directors and don’t take active positions. ETFs also have different ways of investing to produce their target return, with some providers using full replication of the relevant benchmark, where the ETFs purchase the stocks in the index to replicate its performance, while others do it synthetically through the use of derivatives. Many of these investment processes may create further risks for the investor, such as counterparty risk and stock lending. It is also worth remembering that ETFs are financial products, launched by fund managers in order to earn fees from their investors – who do 56
not have the power to change the manager or the mandate if they are not happy. One of the largest benefits that investment trusts have is their closed capital structure. Once the initial funds have been raised and invested, the manager doesn’t need to worry about meeting liquidity requirements from daily flows. This enables them to take long-term investment decisions and to invest in more illiquid (harder to trade) companies than open-ended funds can. Another area to focus on is costs. ETFs are generally sold to investors as low-cost solutions, but a couple of minutes spent on the Morningstar website shows significant dispersion in both total expense ratios (TERs) and performance within similar
strategies. The UK Large Cap Blended sector has a 70bps spread between the cheapest and the most expensive ETF (10bps to 80bps). Fees charged on investment trusts also vary widely, with the UK All Companies sector ranging from 0.25 per cent to 0.88 per cent, but are not significantly higher than their ETF competitors. When making their investment decision, investors should also take into account other costs involved with both ETFs and investment trusts, such as dealing spreads and commissions. In theory, ETFs should perform in line with their index, but perfect replication is not possible. In fact, performance drift is inevitable and the average ETF strategy underperforms the index it attempts to replicate. This
underperformance is in addition to the frictional costs incurred when investing in the product in the first place. Investment trusts, on the other hand, aim to outperform their benchmark. Research produced by Winterflood Securities shows that almost every investment trust sector has outperformed both in share price and net asset value (NAV) terms over the past five and 10 years. Both investment trusts and ETFs undoubtedly have a place in investors’ portfolios, but they are very different vehicles. Any potential investor will have to take time and care in identifying all of the possible risks and costs associated with making an investment into either strategy.
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