Although long-term performance is necessary to judge focus funds properly, they have certainly justified their existence as a serious investment prospect
Both Jupiter and its nemesis New Star have recently launched highly aggressive funds. But are these funds a strong investment prospect or merely a marketing fad to boost ailing mutual fund sales?
Each year the fund industry produces a new fashionable product ' generally funds designed to take advantage of specific market conditions and sentiments of that time. In 1998 and 1999, it was technology that dominated the headlines, with triple-figure returns and stellar performances from names such as Framlington NetNet.
Now the technology sector has been ravaged by poor performance, funds are a fraction of their peak levels and many investors have been left with burnt fingers.
This year, investment houses have turned to focus funds, which run concentrated portfolios with a smaller number of investments. The basic argument is that these should be able to outperform more diversified funds that have a greater number of investments and consequently exposure to major stocks and indices.
But it should be considered whether these are genuinely strong long-term investment prospects, or another marketing initiative to encourage investors, already burnt by falling equity values, to invest again?
Fundamental to understanding this is to look at how focus funds are structured and the rationale behind them. Generally, focus funds might aim for anywhere between 25-40 stocks as opposed to the 60-100 conventionally held in a manager's portfolio. Focus funds operate on a bottom up, or stockpicking approach, meaning they look at companies at a micro level rather than weighting towards sectors or geographical markets.
This should, in theory, mean that fund managers can avoid being impacted by equity falls in major stocks, sectors and markets through limiting exposure to these. Equally, if markets are bullish, potentially much greater returns can be achieved through reducing exposure to slower growing major stocks or sectors.
Focus funds can react far more rapidly, so short-term positions can be taken even if the fund manager dislikes the long-term prospect of a company. This allows them to take advantage of mispricing or market anomalies.
Moreover, the limitation of their exposure to FTSE 100 stocks means that they can avoid following the performance of behemoths such as Vodafone and BP. If carefully managed, this can allow fund to outperform traditional, heavily benchmarked funds. The downside to this is higher turnover, greater tracking inaccuracy and more risk through reduced portfolio diversification.
There is a fundamental reason why investment houses have felt compelled to launch focus funds. Recent equity market booms have left investors with higher expectations of what returns they can expect from their investments. Ten years of sustained US economic growth, compounded with strong UK and European growth, have given some of the highest returns in recent history. But depressed market conditions and atypical world events have made it very difficult for conventional funds to offer the level of returns expected. Consequently, fund houses have offered more aggressive, higher risk focus funds to seek the returns acceptable to today's investor.
The downside of this risk needs to be tempered to a certain degree. First, recent studies have suggested that investors have an appetite for higher yield products. A recent survey by Andersen of high net worth clients suggested that 62% want access to higher risk, higher yield products.
Second, the risk inherent in focus funds should be considered as different to the technology sector, where the embryonic nature of the dot.com sector compounded the risk of the companies within it.
Additionally, with markets currently depressed, there are potentially more undervalued companies that can present strong opportunities for stockpicking fund managers.
Indeed, much of the inherent risk can be attributed to the stockpicking nature of focus funds. Focus funds frequently use short-term trading along with longer-term bets to improve returns. This is reflected in the high levels of annualised portfolio turnover ' for example the RSA Investments UK Prime Fund was operating at a 600% level.
This high level of turnover facilitates opportunistic stockpicking but equally increases exposure to short-term losses and increases volatility.
This is demonstrated by the tracking error found in focus funds, which can be as high as 10% as opposed to the more traditional 2-3% seen in many UK funds. This volatility has to be viewed against the backdrop of atypically volatile markets but has to be considered a risk factor for longer-term investments. It is predominantly for this reason that focus funds have been oriented toward the retail market, where greater risk may be sought.
Empirical evidence however, shows that focus funds are performing well. Gartmore UK Focus is currently ranked first in the All Companies sector for the year to the end of January 2002, Invesco Perpetual UK Aggressive has been among the top funds and BWD Rensburg UK Aggressive has also been the best performing fund over the past few months.
However, this performance, along with any other funds launched over the last three or four months must be tempered with the fact that these funds may have benefited from launching in the dip that accompanied 11 September, and the market has since moved up to correct this atypical undervaluation.
It has not been all plain sailing however. Friends Provident and Fidelity's UK aggressive products have not performed particularly well and are down around 20% over the year, although it should be remembered that this has been in particularly difficult market conditions.
Empirical evidence would suggest the majority of focus funds have performed well then, and in most cases have justified the launch. There is no doubt that the stockpicking approach seems to be particularly suited to current market conditions.
The downturn we are experiencing is more akin to the pre-war boom-bust investment cycles than the commonly seen inflation-lead recessions of the eighties and early nineties. Boom-bust cycles give rise to greater market volatility, which in turn presents more anomalies and mispricings for fund managers to exploit. Focus funds have the flexibility to take these opportunities, whereas conventional funds are constrained by benchmarking requirements.
It is worth considering the current spate of funds are relatively new, and looking at performance over the longer term will indicate how the funds perform through cyclical changes. Since market conditions are atypical, recent performance is unlikely to present a guide to future returns.
Nonetheless, it is fair to say that focus funds have justified their existence as a serious investment prospect, despite arousing sceptical glances with marketing as aggressive as the funds. However, in the context of falling mutual fund sales and faltering investor confidence, these funds are a welcome addition to the investor's potential arsenal.
And with equity values bottomed out and volatility high, they may have timed their launch to perfection, offering strong returns from launch. If investors are indeed looking for return levels similar to the nineties, focus funds may be one of the few options that can actually deliver.
The basic argument is that focus funds should be able to outperform more diversified portfolios.
The limitation of exposure to the FTSE 100 means focus fund managers can avoid following performance of huge companies such as Vodafone and BP.
The tracking error in focus funds will be as high as 10%, as opposed to the traditional 2%-3% seen in most UK portfolios.
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