Although not as important as determining your investment objectives or the long-run asset allocation for your portfolio, choosing the best managed fund can make a real difference both in terms of likely investment returns and the fees you will pay.
- There is a lot of available information on individual managed funds and you need to take the time to do some research.
- Intermediaries such as financial advisers and brokers have access to professional research and approved product lists.
- Headline investment returns are not everything, as sometimes they hide biases that can hurt your portfolio when the market changes.
- It is important to understand who will be looking after your investments, the credentials of their company and their investment track record.
Choosing managed funds can be one of the most complex endeavours an investor can undertake. But it doesn't have to be. The reason for the complexity is that there is a large and significant industry devoted to gathering your assets for management and charging you fees. While there is nothing wrong with that, it can make the task of selecting the best managed fund for your purposes more difficult. But with a bit of guidance and commonsense, most investors can navigate through this information to find good managed funds that will suit them.
While individual investors can do a lot of the research themselves, the most common approach is through the use of intermediaries, such as financial advisers or brokers, who have access to high-quality professional-grade research. This professional research comes from both within the organisation the intermediary belongs to and without (such as expert research houses). This ensures that recommended managed funds pass a minimum quality filter, which should protect the investor from products that would not be considered fit for purpose.
Individual private investors can still access a fair amount of quality information on individual funds using the internet. Managed fund product managers, responsible entities and investment managers have fact sheets and performance reports on individual funds that are updated regularly, usually on a monthly or quarterly basis. Note that if this information isn't easily available you should take it as a warning sign to be wary of investing in that managed fund.
While it is very important to assess managed funds' fees, the fees in themselves aren't so much the issue as what your investment return is after the fees have been deducted. You should be assessing investment performance against a relevant benchmark, for example, if the managed fund invests in Australian equities you should compare it against the Australian stockmarket index to gauge whether it is achieving returns above the index or if it is underperforming.
How the managed fund operates is also important, for example, is there an underlying investment manager of the fund and, if the managed fund invests, say, into international equities, does the Australian fund manager outsource this to global investment managers? This leads to the question of whether there is a coherent and clear explanation of how the fund has performed in the current market environment and why.
These major pieces of information should be contained in the managed fund's product disclosure statement (known as the PDS). This is the single most important document about the managed fund. While PDSs can vary in size and complexity, the product information they contain will be invaluable for helping you compare and contrast your managed funds.
What investment experts look for
A good guide when comparing managed funds is to think through what investment experts look for and to model your own comparisons on how they do their own research. Doing this might seem difficult, but by following the steps outlined below you will gain insights that will bring you very close to looking at managed funds just as the experts do.
- Investment philosophy: A manager's investment philosophy represents the firm's basic set of investment beliefs. For example, if it is an active investment manager their philosophy usually states that the manager believes markets are inefficient (meaning that the manager can outperform the markets after fees if it follows its investment process). Index managers, on the other hand, may not have an explicit investment philosophy other than saying their goal is to match the market index as closely as possible. Note, however, that some managed fund operators will have several funds and each may work differently, so understanding the breadth of these funds can also give you an appreciation of how they run their managed fund business.
- People: The quality of the investment executives and their staff, their relevant experience and formal educational qualifications are really important. While there are many qualified and experienced people in funds management, the more important goal is to weed out investment managers with dubious qualifications (or none at all). Another aspect of this is how investment teams are organised as some investment teams have lead portfolio managers who make all the decisions, while others have more collegiate teams where everyone is responsible for how portfolios are constructed. Look for investment managers with many years of experience and teams that have worked together for substantial periods of time.
- Process: This includes the approach that the investment manager uses to put its philosophy into practice. For example, if the manager strongly relies on going out to see individual companies and their management while building complex financial models, does the investment manager have the quality and quantity of resources (including people) needed to do this? If a more quantitative approach is taken using complex mathematical models, do they have the computing power, databases and intellectual rigour to put this into practice? If they are an index manager, do they have the systems in place to ensure trading costs are as low as possible?
- Research: This is about generating investment ideas, that is, an investment manager's ability to come up with insight and ideas about how other people's (your) money should be productively invested. In equities this is about reducing the number of companies in the investment universe to a manageable size. In high-yield fixed income this is about generating deal flow, meaning getting access to new issues of fixed-income securities. While managers should generate most of their ideas internally, it is worth knowing which external researchers they use and how this is paid for. Sometimes broker research is paid for by directing trades to that broker. If this is the case it is good for their fund manager clients to know.
- Portfolio construction: This involves (depending on the specific asset class) how the portfolio is constructed and within what limits. This could include weights to individual securities (whether shares or bonds), country weights, sector weights and limits to different credit ratings. The portfolio construction process should ensure the client gets the overall market return while giving the investment manager enough freedom to generate returns in excess of the benchmark index through their investment process and idea generation.
- Ownership and funds under management: Ownership by a large global group could be seen as an advantage due to stability and deep pockets which can provide development costs where needed. Alternatively, a small boutique manager, the number of which has expanded significantly over the past 20 years, may be preferred due to the perceived greater skill and flexibility of the investment managers. Some investment insights only work on a small amount of money (relative to the size of the market). In some of the smaller, less liquid markets (such as small companies and distressed debt) managers can only manage so much money before their trading affects the market and their ability to generate excess returns - this is sometimes called the capacity constraint. Self-imposed limits on funds managed can give the investor confidence that the manager puts the investor before corporate revenue.
- Performance: While investment performance is, of course, an important factor, remember that you cannot buy past performance. Performance numbers show how the fund performed at a point in time during specific market conditions. If those conditions were repeated one would expect similar performance. However, market conditions are always changing. If a growth-oriented equities fund performed well when growth company shares were outperforming, you would not expect it to repeat that performance when value stocks are rising. It follows that if you believe future conditions would favour value stocks, it would be a mistake to go overweight in growth stocks. Some of the technical things that investment researchers might measure include:
- Relative performance (i.e., against an appropriate benchmark index).
- How much active risk was taken. This is measured by the difference between the fund return and the benchmark return (specifically, it is the volatility or the extent to which this gap changes).
- How much market risk was taken. This is measured by how much the investment return of the fund and the return of the benchmark tend to move in the same direction
- An investor in an actively managed fund wants both active risk (in order to generate outperformance) and market risk (to access the returns from the asset class).
- Fees: If you are paying fees above what you would pay for an index fund, you are paying for both the intellectual property of the manager (their unique investment insights) and the skill with which they implement their insights into your portfolio. Note that unique investment insights don't stay that way forever. If they work, they are often copied over time by other investment managers and can then be delivered at a lower cost. This is the free market at work, so don't overpay for something you can get more cheaply elsewhere. Some fees are difficult to understand, particularly performance fees. If you don't understand the fee structure in a managed fund, be very cautious about whether that product is suited to your needs.
- Back office and compliance: This area does not necessarily directly affect performance but may relate to efficiency of trading and implementation of the investment decisions made. However, it
does directly influence the quality, timeliness and accuracy of reporting to the investor.
Fund research factors to consider
- Investment philosophy
- Portfolio construction
- Funds under management
- Back office and compliance
Active manager returns for periods to December 2021
|3 years pa
|5 years pa
|Standard deviation* pa (3 years)
|Tracking error^ pa (3 years)
Source: FactSet, Rainmaker Information
Indexes: S&P ASX 200 - Index Total Return; MSCI AC World ex-Australia in AUD | *Standard deviation represents the volatility around the average return | ^Tracking error is a message of the risk taken by the manager versus the benchmark index