Matching the needs of an investor to appropriate funds in terms of risk can be a difficult and time-consuming task but is one that warrants much consideration in the wake of depolarisation and depressed stock markets
At the heart of any tax-efficient investment solution lays the risk versus reward equation: it is simply impossible to reap reward without taking some form of risk.
Matching the individual needs of a client to appropriate funds from a risk perspective is, however, a difficult and time-consuming task. But one, nevertheless, that warrants much consideration as we confront the challenges ahead in the wake of depolarisation, N2 and stock markets that remain heavily depressed from levels two years ago.
All investment managers share the same goal ' to stack the odds in favour of the investor. So how should you go about it? A number of factors are key to arriving at an appropriate investment solution for clients within an accepted risk/return profile, but a good starting point is to take a methodical approach towards asset allocation.
It is all too easy to get carried away with heartfelt views about the relative attractions of the various stock markets around the world. The developing world, for example, can offer superior growth prospects but this invariably entails a greater risk. Similarly, many well-regarded investment houses have continued to believe that the US equity market is overvalued, forgetting the old adage that when America sneezes, the rest of the world usually catches a cold.
The answer must surely be to accept fallibility and diversify by pursuing a structured, gradual asset allocation process around a sound and internationally accepted benchmark.
Risk can be reduced further by style diversification within an individual market. Growth, value, blend, sector specialist or small caps are just some of the identifiable fund management styles available to investors.
A strong argument can even be made for diversifying within each of these styles, as fund managers' performances will inevitably fluctuate. Not to diversify seems to be missing an important opportunity.
Like diversification at the geographical level, investors should use experience and knowledge to tilt portfolios in favour of those that are likely to outperform at a given time, but unless you have 20:20 foresight, it is important to keep a good spread of styles at all times.
A large component of potential outperformance, particularly if portfolios are run against relatively defined global, regional objectives or pre-determined fixed interest/equity guidelines, is to be found in the selection of funds. But dealing with increasingly complex financial issues and sophisticated customers is placing an unenviable strain on the resources of the financial intermediary at a time when the task of identifying suitable funds for inclusion in portfolios is arguably becoming ever more time-consuming, particularly if it is done properly.
Significant variation in share prices over time is considered an occupational hazard in the investment world and unit trusts are conceptually designed to diversify such specific risk. But in reality, the variation across the main unit trust sectors is surprisingly large.
A quick glance at the one-year performance numbers to the end of February 2002 shows just how difficult it has been. According to Lipper Hindsight, the best UK All Companies fund was up 16%, bid-to-bid with net income reinvested, with the worst fund down 50%.
The difference between the top and bottom UK Smaller Companies funds was a staggering 75%. The difference between the best and worst fund covering all sectors was a huge 134%, with the best up 69% and the worst down 65%.
Three-year data makes just as bad a read. Of 1,025 funds screened by the Credit Suisse multi-manager team, only 89, or 8.7%, were consistently above average in their respective sector three years in a row, with just 15 funds consistently top quartile.
But a sound fund selection process can dramatically improve these poor odds.
One of the best ways to look at fund selection is to screen funds over discrete periods to establish the consistency of returns, which should then be matched to the market conditions prevalent during these periods.
Importantly, when screening, existing knowledge of a fund should be used to help establish whether there can be a realistic expectation of a repeat performance from a seemingly good fund.
Screening should be carried out on a monthly basis to help identify funds that are consistently above peer group averages. Such filters can also help unearth up-and-coming funds that might not normally be considered.
Whereas past performance is very often no guide to the future, studies can confirm consistency of return, which is a better guide to repeatable performance. The composition of the peer group against which performance of a fund is being measured is also of significant importance in drawing some initial conclusions.
Fund selection should take into account a fund's volatility to assess whether the degree of risk employed is consistent with returns seen. For new funds, or where a change of manager has occurred, every attempt should be made to obtain alternative relevant statistics scrutinised in the same way.
Once a fund has been identified as a candidate for further research, the investment process should begin in earnest.
At Credit Suisse, we start with a questionnaire that has been refined over many years to glean all of the pertinent answers to appropriate investment-led questions. We will also style analyse the portfolio using software packages for further insight into risk. For example, is the tracking error of a fund made up by a small number of very active bets or is the risk load spread more evenly throughout the portfolio?
Fund structure, size and capital flows to and from the fund are also detailed and concentration studies and correlation analysis form a key part of the portfolio construction process.
Crucially, an assessment of the individual manager(s) should also be undertaken at the time of review, including expertise, CV and general level of experience and knowledge. Self-confidence is often a good sign but strength and depth in the team is a highly desirable feature.
Enquiries should also seek to establish what flexibility exists for the managers' approach to differ from either house policy or from any model portfolio. The main aim of such in-depth research and subsequent meetings with managers is to establish whether the same people are doing the thing in the same way as when the track record was established.
Having gone through the selection process, carried out all of the preparatory research and interviewed the manager, conclusions must be drawn. But here, once again, it is important to adhere to a formal process, such that the emotion attached to meeting with highly talented individuals can be removed from the final decision.
At Credit Suisse, we use a 16-factor proprietary scoring system. Organisational and portfolio features are considered as both are deemed important to the quality of a fund. Of course, some of these factors are considered more important than others but a good score across the board is preferred.
In constructing a portfolio of funds, it is relevant to assess the market capitalisation of the stocks held across the entire aggregate portfolio, or the country/sector allocation of the constituent funds as well as those seen as potential replacements. In this way, it is possible to understand the extent to which overall positions are at variance with the market as a whole and what composite risk is being taken.
Copious amounts of statistics can be produced to show that it is extremely rare for one fund management group or one style to succeed in all different types of market conditions. Intensive application of what amounts to basic common sense is, after all, what we strive to achieve by not putting all our clients' eggs in one basket.
A fund of funds is highly tax efficient for clients in this rapidly changing investment world. Backed up by a sound investment process with a well-established team and good software support, this arguably offers the best and most efficient solution. Risk can be reduced, returns enhanced and disappointment largely avoided, as long as you are prepared to put in the hard work.
A large component of potential outperformance is to be found in the selection of funds.
One of the best ways to look at fund selection is to screen funds over discrete periods to establish consistency of returns.
Fund selection should consider volatility to assess whether the degree of risk employed is consistent with returns achieved.
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