Intended to deliver outperformance over the long term, focus funds can be profitable but volatile. Simon Hildrey explains how advisers need to be sure what they are buying
Buying your favourite stock ideas should hardly be a revolutionary concept. Funds that only invest in their manager's best ideas, however, have been some of the biggest selling products over the past few years. But - as with Longfellow's little girl with the curl - when they are good they are very, very good, but when they are bad…
Whether they are known as focus, alpha or aggressive funds, this type of fund is intended to deliver out-performance over the long term by having the freedom to be able to invest in any stocks in any part of the market. The performance of these funds, however, can be volatile. For example, the Invesco Perpetual UK Aggressive fund is the second best performing fund in the UK All Companies sector over three years to 18 April 2005, according to Standard & Poor's, but 64th over one year. Axa UK Opportunities comes 53rd over three years and 287th over one year.
Two of the more consistent funds are Rensburg UK Select Growth and Merrill Lynch UK Dynamic. The latter is ranked 24th over three years and fourth over one year. In the three years to 18 April 2005, the Rensburg UK Select Growth fund, managed by Mark Hall, returned 55.22%, which made it the fourth best-performing fund in the UK All Companies sector. Over the past year, the fund has returned 21.47%, making it the eighth best performer.
Recipe of success
Hall suggests that his fund has suffered less volatility than other alpha funds because he ensures he has exposure across most, if not all, the sectors in the FTSE stock market. "We do not focus on just a few sectors even if we hold fewer stocks than conventional funds. I am surprised at the sector allocations of some of my competitor funds in the alpha sector. I would not be comfortable with the degree of sector concentration they take. We do not hold more than 10% of the fund in just one sector, for example."
He adds that another factor in limiting volatility has been to try to find value anywhere in the stock market, including among growth stocks. "We have a strong sell discipline as well. As soon as stocks reach our target price, they are sold. We are also careful about our exposure to small caps to ensure there is always liquidity. The smallest company we own has a capitalisation of around £40m."
The fund began life with just 35 stocks but it has grown in size to around £150m, with the number of holdings growing as well. "As the flow of new money increased, we had to decide whether to top up our existing holdings or buy new companies. We decided to do the latter. As our original stocks reach their target price so the number of companies will reduce but we currently have around 70 holdings."
Hall says he believes the team can successfully manage a larger fund as long as the assets come in steadily rather than in big chunks. "We have to work harder and make quicker decisions. But we are learning all the time and adding resources."
Despite the freedom to find investment opportunities anywhere in the stock market, however, Hall says alpha funds are not able to outperform in all market conditions. "It is naïve of anyone to think this. We would underperform in a liquidity-driven rally. Indeed, I would hope we would underperform as any short-term gain in such conditions would be at the cost of long-term performance of the fund. As the top 10 stocks in the FTSE comprise such a large part of the market, if we returned to the bull market of the late 1990s we could not outperform."
This is a theme picked up by Gary Potter, co-head of the Credit Suisse Asset Management Portfolio Service. "Alpha funds are not a homogenous group. They adopt different ways of trying to achieve outperformance and take various levels of risk. Some will have very focused portfolios of 25 to 30 stocks while others may have double this number of holdings but be unconstrained by their benchmark."
One of the main characteristics of alpha funds is the freedom to find investment opportunities wherever they can. Multi- managers like the ability of alpha fund managers to back their convictions with significant portfolio weightings. If a manager does not like Vodafone, for example, he can have no exposure rather than simply underweight the benchmark weighting.
But Potter warns that this flexibility does not prevent these funds losing money in the short term if the stock market heads southwards. "It is very hard for long-only funds not to lose money if the market falls."
Sam Liddle, fund of funds manager at Miton Investments, says alpha funds should be used strategically. "We make active macro asset allocation decisions in our funds. When we like a market such as Japan, we will invest in funds that can ride the growth as much as possible. For example, Hideo Shiozumi, manager of the LeggMason Japan fund, takes a relatively aggressive approach and does well when the market is strong. I would not be invested when the market is struggling, however. By combining funds that take this approach, the overall risk of the portfolio can be reduced."
Risk is an important consideration when investing in alpha funds. Conventional theory might suggest that concentrated portfolios are high risk as they are taking big bets against the index. But academic studies have argued that investors can gain adequate diversification through portfolios of just 18 stocks.
Jason Britton, fund manager at T Bailey, says the risk profile will vary from one fund to the next and depend on market conditions. "We like alpha funds as they can just invest in their best ideas. This is particularly so when markets are moving up slowly or are in a sideways environment. In theory, they can still make money in these conditions."
It is argued that with an alpha fund, the manager and his team are even more important than for mainstream funds. Britton says it is vital for investors to understand the investment process used by the manager and in which market conditions he is likely to perform well. "Another consideration is the risk appetite and time horizon of the investor."
A further factor is the amount of assets managed by an alpha fund. A logical conclusion of their focus on the best investment ideas is that there should be a limit to how many assets an alpha fund can manage. Britton says: "A fund should be able to manage £300m to £400m. But once assets under management start rising above £1bn, it may be harder for the manager to deliver out-performance."
Toby Ricketts, manager of the Margetts Select Strategy fund, stresses the need to fully understand alpha funds. "Richard Buxton's Schroder UK Alpha Plus fund has had a difficult year [over the past year, it is ranked 278th out of 293 funds in the UK All Companies sector]. Some multi-managers have been redeeming and switching into the Merrill Lynch UK Dynamic fund.
"But investors need to understand the exposure of the Merrill Lynch UK Dynamic fund. It has a relatively large exposure to commodities, such as through mining stocks. You have to take a view on whether Mark Lyttleton can continue to get these calls right. Alpha managers seem to have their favourite sectors. Richard Buxton has always been keen on banks."
Over the long term, Buxton has delivered great performance, says Ricketts, but he adds that investors need to accept they will make some mistakes because of their investment approach. "Alpha managers should be held for the long term, which is around three years." He adds that the strongest outperformance from alpha funds will be in sideways-moving or cautiously rising market but will underperform in rising bull markets such as the late 1990s.
The rough with the smooth
Tim Cockerill, head of research at Rowan & Co Capital Management, says performance is mixed with alpha funds and generally investors have to accept volatility. This is logical if a fund only holds between 30 and 40 stocks in a portfolio. If an alpha fund manager gets a couple of stock calls wrong, it will have a greater impact on performance than with a conventional fund. But, of course, the reverse is true as well - returns can be boosted far more by individual stock performance in an alpha fund.
"A good example is a stock like Cairn Energy, which has been held by a number of alpha fund managers," says Cockerill. "If a stock like this falls from £15 to £10 and it comprises 5% of a fund then it will have a major impact on performance. It is important to look at the investment approach of these funds and I cannot help but wonder if they take on the style characteristics suited for the market conditions of when they are launched."
Despite the risks, Cockerill says Rowan & Co does use alpha funds in client portfolios. "We may allocate a small proportion of our portfolios, such as 5% to 10%, to try to generate some extra return for clients." Among the funds that Cockerill highlights are Merrill Lynch UK Dynamic and Newton UK Opportunities.
Alpha funds should be bought on the understanding that they are for the longer-term. They allow good managers to derive most benefit from their stockpicking skills, but they also give not-so-good managers the chance to back bad ideas. With these funds more than most others, advisers need to be sure what they are buying.
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