How to choose a fund - Part 3

The most important thing for the new investor is preservation of capital and not, necessarily, increase in capital. The best way to do this is by diversification. The easiest way to understand this is if you have shares in ten companies and one of them loses a lot of money then you will feel the loss heavily. If you have the same amount in each company then you will, naturally, lose ten percent. If you had access to ten times the amount of companies the risk is massively reduced. However, you will have had to pay a small fortune in stockbroker fees thus making the point of diversification a bit meaningless.
Whilst understandable, it means that many investors have only a few different shares and so can, potentially, leave themselves over-exposed to risk. By investing in funds, the risk is reduced as the fund pulls together all the money put in by investors and so optimises its buying ability whilst reducing the chance of poor performance due to one or two stocks. Putting it basically, by making one payment into a particular fund you are buying many stocks and shares which you may not be able to do or afford if you try to buy them individually.
The next question is what happens to your money now that it is in the fund? Well, you will have done your due diligence and selected the fund(s) that most suit your own criteria. The fund manager, as stated above, will have declared the fund objectives in the literature you will have read. He will always have this in the back of his mind when choosing which stocks and shares to purchase.
Let us look at these Fund Objectives in more detail. What do they actually mean? Well, someone like Martin Gray, who runs the MitonOptimal Special Situations Fund, has a Fund Objective which states, “The Offshore Special Situations fund invests into the CF Miton Special Situations fund and is a global multi asset fund with specialist exposure to investment trusts, mutual funds, direct equities, ETFs and structured products. The fund is not constructed or managed against a specific index or benchmark. The performance objective is to achieve long term returns above inflation over the course of the full investment cycle. The consistency of returns throughout various market conditions and superior long term track record make the fund suitable for long term investors looking for a core holding within their portfolio.”
Whereas the Aberdeen Asian Smaller Companied Fund team has something that says, “The fund’s investment objective is long-term total return to be achieved by investing at least two-thirds of the Fund’s assets in equities and equity-related securities of Smaller Companies with their registered office in an Asia Pacific (excluding Japan) country; and/or, of Smaller Companies which have the preponderance of their business activities in an Asia Pacific country (excluding Japan); and/or, of holding companies that have the preponderance of their assets in Smaller Companies with their registered office in an Asia Pacific country (excluding Japan).”
And Pictet Water adheres to, “The sub-fund seeks capital growth by investing at least two-thirds of its total assets in the shares of companies operating in the water and air sector worldwide. The sub-fund favours companies operating in water supply, processing services, water technology and environmental services.”
As you can see, each is different and has its own set of instructions as to what it is to do to try and achieve its goals. The fund manager must adhere to these guidelines.
Okay, so now you have your fund and you know what the objectives are. However, there are different ways to invest. For example, is this the same as active and passive investment? Which is better? People have written books on the subject and we do not have the time or space to go into this in much depth. However, Adam Smith of Lancaster Pollard has written an excellent article on this and it basically says that, “While many institutions are focused on whether active or passive management is the optimal solution for the entire portfolio, a more sophisticated approach is appropriate. Rather than focusing exclusively on one or the other, institutional investors should better understand the nuances of certain active and passive strategies. Doing so can provide an opportunity to use both active and passive as complementary solutions within an institutional investment portfolio.”
This is exactly right. Adam goes on, “Often, institutional investors define all investment strategies as either actively or passively managed. In reality, however, each of these two strategies can be further defined, which can lead to differences in both expected returns and volatility. One way in which actively managed strategies can be defined is by the number of holdings: those that are more concentrated versus those that are more diversified.”
The most important thing here is to understand the risk/reward ratio of both active and passive fund management. The former gives the investor the chance to outperform any benchmark (alpha) and so get better returns - it also means you can do worse and so not do as well. The latter, passive fund management, can often mean just tracking a benchmark but even this can be further defined as passive and smart beta. Whilst passive beta means just following the benchmark per se, with smart beta the fund manager can choose how much he invests with each company in the benchmark.
After understanding the particular difference between the various types of active and passive strategies, an investor can now focus on taking advantage of them within his/her own portfolio.
Now you know the difference between active and passive and alpha and beta, what type of fund is best suited to your needs? Do you need money from the fund on a regular basis or can you leave it for long term growth? If the former then an income fund will be better suited to you; however, a growth fund will be best for those who do not need the money in the short term as any gains will automatically be reinvested.
Now we have to look at yet another factor, funds can be further categorized by sectors and geo-political regions; i.e., a particular sector may be healthcare or financials whereas a geo-political fund may invest in Asia or Europe.
As you can see, choosing a fund is not easy and if you are not confident then it may behoove you to select a multi-asset, multi-managed fund so you get the best (or worst?) of all worlds.
Each investor, as stated before, has an agenda. Bearing this in mind they also need to choose on how aggressive, balanced or cautious the funds are. The usual way of doing things is to have a certain percentage in all of them once it is known which funds fall into a particular category.
There are tens of thousands of funds in most jurisdictions and so there should be something to cover what is needed for your own particular portfolio. Remember, no-one has a monopoly on good ideas and so it would be wise to diversify as much as possible - at least until you get a good feel for how funds actually perform.
Do not be deterred by the amount of funds. Things are not as horrendous as they may seem. First, think about what you want and have a good look at the funds you think will suit your risk/reward ratio - basically, the higher the number, the more risk you are prepared to take.
The most important thing of all is to decide if you want capital growth or regular income. If it is the former then you should consider more equity based funds, hedge funds, commodities and stocks and shares of various companies in different countries - frontier and emerging markets may constitute part of what you need. If it is the latter then you should be looking at bonds (I would normally recommend a mixture of sovereign and corporate bonds but the debt of certain countries at the moment puts me right off), income funds, good yielding stocks and shares - you can never really go wrong with any company that offers a P/E ratio between 5 and 14 with a yield of around five percent.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]