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The Definitive Guide to Unit Trust and Investment Trusts - Part 2 By Martin Fagan As we saw in part one of this report, if you have an investment objective, an investment fund can help you reach it. Whether you need to get exposure to investment areas or asset classes you don't have much expertise in, such as the emerging markets of India, China, Russia or Brazil, or else asset classes such as commercial property, commodities and precious metals or corporate bonds, you'll find a fund that invests in it. In this second part of this special report, we'll look at various types of investment funds you might want to consider for the coming ISA season - Focus (or Alpha) funds for those who like a bit of spice in their portfolio; for investors looking to tap into companies that pay dividends (whether to be paid out as income or reinvested in the fund) and get some tax breaks, we look at Distribution Funds. Finally, for those who like to leave a portion of their investment to be controlled by the market rather than a fund manager, we look at Tracker Funds and Exchange Traded Funds. Focus/Alpha Funds Just as some investors who invest in direct shares have an area of their portfolio where they run some riskier companies they hope will reward them handsomely, so do fund investors and many like the idea of funds that throw off the shackles of a benchmark and gave the manager his/her head to invest in stocks at the fringes of the normal investment radar. In 2002, just as the UK investors were starting to regain their appetite for risk and look once more to the stock market, a new breed of funds was being pushed at investors who were prepared to take some risks in the hope of earning better returns than mainstream funds could deliver. Focus funds, alpha funds aggressive funds - whatever they're called, they all have several attributes in common. A focus fund invests in a small number of companies (hence its name) - usually fewer than 50 and sometimes only 25 - and the managers have no constraints on which companies to buy. These are both factors most investors are likely to support. In contrast, many mainstream funds have more restrictive investment mandates that prevent managers from being able to put up much defence against the effects of a falling stock market; with focus funds those shackles have been taken off. However, as there is such a small pool of stocks in the portfolio, each plays an important role in the returns of the fund. If the manager gets it wrong, this has a big impact on fund's performance. But if the manager gets it right… He or she adds "alpha", but to understand alpha you first have to understand "beta". Beta is one of the many bits of jargon in the fund management industry. Beta is the value added to - or subtracted from - a portfolio by the market. In the case of fund management, more specifically the index (or indices) the fund is benchmarked to. Alpha is the value added by a fund manager after stripping out the effects of the market (beta). So if your fund had grown by 30 per cent over three years and the benchmark index (the beta) had increased by only 15 per cent over the same period, then the fund manager is giving you 50 per cent more (the alpha) than the market on its own is giving you. Therefore, an Alpha fund is in the business of leaving a nominal benchmark index choking on its dust. So the defining feature of a focus fund is its concentrated portfolio of stocks; but, beyond that, they still differ quite substantially. Managers may, for instance, concentrate on different types of stocks, favouring small and mid caps over large caps for example. This is the approach from the New Star UK Alpha fund. Its manager, Tim Steer, looks for companies that are operating in defendable or growth markets, targeting those with strong sets of accounts, good management and strong cash generation. Steer says he finds most of these types of companies reside in the FTSE 250 and the portfolio is typically 60 per cent weighted in mid-caps, with around 12-15 per cent in large cap stocks. Nevertheless, this approach has hit performance numbers. Over five years, the fund is up 160 per cent against a rise of 99 per cent in its IMA sector (the catch-all UK All Companies); but over three years, the fund is up 37 per cent against 26 per cent for the IMA sector. However, it is worth comparing this to two funds that consistently concentrate on larger stocks (and operate in the same IMA sector): Schroder UK Alpha Plus and Martin Currie UK Growth. The Schroder fund is an "alpha" fund but the Martin Currie fund is a standard UK Growth fund. Over five years, the Schroder fund has gained 138 percent (compared with 160 per cent for the New Star fund), but over three years it has gained 48 per cent (New Star fund up 37 per cent). But the Martin Currie fund is only up 79 per cent over five years, which is not only below the performance of the New Star and Schroder alpha funds, it's well below the average of 99 per cent in its IMA sector. Over three years, the Martin Currie fund has returned a dismal 14 per cent (IMA average 26 per cent over the same period). We might at this stage also flag the t1ps SF smaller companies fund. Its chief manager Tom Winnifrith has a great record as a stock picker for newsletters and in the first three months of its existence he has outperformed benchmarks for both small caps and for the wider market handsomely. Oddly Tom's best performer to date is also the second smallest company he has backed and his fund has a 5% stake in that company. Tom's fund will not invest in more than 30 companies on the basis that if fund managers spread their attention too widely their efforts will be dissipated. So far that strategy is, despite the poor market for small caps, paying off. So Focus/Alpha funds do add value over more conventionally managed funds. Nonetheless, a second important distinguishing characteristic is the risk management approach. Broadly speaking, the more risk controls that are in place the less likely it is that fund manager's mistakes will be too costly, but any restrictions - however slight - can potentially limit potential profits. As focus funds typically hold small highly concentrated portfolios of 30 or 40 stocks, compared with possibly 100 in a more mainstream fund, with so few holdings any bad misjudgement will inevitably have a marked affect on the overall return, which is why the choice of manager is absolutely crucial with this type of fund. The key is to find an experienced stock picker who can put together a portfolio of winners that over time will produce consistent returns. One of the key things to look for is a fund manager with a record of accomplishment in all market conditions; it's also important to consider the areas where the manager invests, as this will govern how the fund fits into the rest of your portfolio. At the t1ps SF smaller companies fund the two lead managers have a combined 59 years market experience so claim to have seen more market swings than most! Similarly, a change in fund manager can have an even more profound effect on a focus fund than on a more mainstream product. The departure (in November 2005) of the well-respected (and colourfully named) Adriaan de Mol van Otterloo from the Schroders European Alpha Plus fund may have created concerns were he not being replaced by the equally regarded Leon Howard-Spink, formerly of Jupiter Asset Management. If you're looking for a focus fund, you should definitely investigate the Schroder UK Alpha Plus fund. At £1.5 billion in size, it might be a bit on the big side for many people who could argue that a focus fund needs to be small and nimble. However, as we have seen, you can't argue with its performance. If you prefer a smaller fund, the Jupiter UK Alpha fund is currently a mere £14 million in size, but its numbers are respectable (142 per cent over five years and 40 per cent over three years). And, so far, the performance of the new kid on the block, the t1ps SF Smaller Companies fund, which manages less than £4 million definitely merits some support. Even at £1.4 billion in size, the Blackrock/Merrill Lynch UK Dynamic fund is also one to watch, returning 160 per cent over five years and 38 per cent over three years. One focus fund that is having a particularly torrid time at the minute is the Gartmore UK Focus fund. Its current numbers are not as good as the other funds I've mentioned (101 per cent over five years and 20 per cent over three years) but the fund's managers - Simon King and Ashley Willing - run Gartmore's institutional hedge fund and the Gartmore UK Focus fund is a replica of the hedge fund's "long" portfolio that's available for private investors (rather than institutions such as pension funds, private banks and the like). Unusually, the fund also has a performance-related fee, whereby if it is not in the top quartile in any particular quarter it will refund part of the management charge. Focus funds create excellent opportunities and investors should include them as part of a balanced portfolio and should hold them for the long-term. They are best used to add aggression around the core holdings with approximately 5 per cent to 10 per cent of the overall portfolio invested in this area, depending on your appetite to risk. Distribution Funds Traditionally this type of middle ground investment has largely been the preserve of insurance companies; but with-profits funds have been so out of favour that investment managers have been able to step in and fill the gap. The result has been the creation of a number of new distribution funds, with launches by the likes of Jupiter, Invesco Perpetual and New Star. Other managers meanwhile have chosen to re-classify suitable existing products. Distribution Funds invest in a mixture of fixed interest securities and shares to produce a reasonable level of income together with the prospects of capital growth. They are ideal for investors who want to gain some exposure to the stock market without taking too much risk. It should go without saying you can't expect these funds to give you as much capital growth as a pure equity fund, regardless of how aggressively skewed its portfolio is. Distribution funds are structured so that capital growth and income can be separated from each other. In most cases, a significant part of the portfolio is invested in fixed interest stocks (corporate bonds, gilts etc.) to provide the underlying income. The other main investment is in usually in income-bearing equities to provide further income and give capital growth potential. The investment philosophy between a Distribution fund and a with-profits fund is similar in that they each invest the majority of their fund in equities (usually between 40 per cent - 60 cent) and fixed interest investments. For many who have, say, a with-profits endowment with a life company, distribution funds look exactly like with-profits and there is a tendency for those people to ignore them. However, despite the fact they look similar on the surface, there are major differences between a distribution fund and a with-profits fund. For one thing, the unit price of a distribution fund fluctuates as the values of the underlying investments fluctuate, whereas a with-profits fund will attempt to smooth out these underlying fluctuations. The result of this is that the workings of a distribution fund are more transparent than those of a with-profits fund. The unit price of a with-profits fund will only move upwards and this is the result of the smoothing process, whereas the unit price of a distribution fund can fall as well as rise as the underlying investments fall or rise. To compensate for the additional risk of a distribution fund (ie, it can fall) there is additional growth potential if equities perform well, as these funds will immediately benefit from the full equity growth in the portfolio. Funds that hold a minimum of 60 per cent of their portfolio in fixed interest are treated differently for tax purposes than those that have a greater equity exposure. The near two-thirds fixed interest weighting means that distribution funds are officially defined as bond funds and, as such, are considered to pay interest rather than dividends. As far as income seeking ISA investors are concerned this makes them a tax efficient option, since the ISA manager will be able to reclaim the 20 per cent tax deducted at source from the income. Most distribution funds are classified in the Cautious Managed sector; when looking at them, you want to look at both the yield and the return, but use them separately as analytical tools. If you are looking for income, look at the yield and the performance of the income unit (usually listed as "INC") so you know how much income you can expect and how your capital is growing. If you are reinvesting the income, you need to look at the overall return so look to the accumulation units - "ACC". The performance of the income unit will lag behind that of the accumulation unit because the income unit is paying out a percentage of its growth as income. In addition, because the income is factored out, income units are cheaper to buy than accumulation units, which have more of a call on the fund's capital growth via the reinvested income. This means you cannot chop and change between the two separate types of units as you've have to sell one and buy the other, a luxury for which the fund manager might not charge you, but you'll be hit by selling one type of unit for the bid price and buying the other type at the offer price. In all that feels a little confusing, let us take for example the Jupiter Distribution Fund. As of the 3rd week in February 2008, the fund was yielding 3.9 per cent. Over five years, the accumulation unit had grown by 34.8 per cent and the income by 33.5 per cent. The offer price of the accumulation unit was 66.99p and the offer price of the income unit was 53.32 per cent. Another distribution fund to consider is AXA Distribution. This pays out a lower yield than the Jupiter fund in return for better capital growth because it has more of its portfolio in equities than fixed interest. It is currently yielding 2.85 per cent but, over five years the accumulation unit has grown by 54.6 per cent and the income unit by 51.4 per cent. Another good performer is the F&C Managed Distribution fund. This also has a slightly higher weighting in equities but is currently yielding 4 per cent and, over five years, the accumulation unit has grown by 55.8 per cent and the income unit by 50.3 per cent. Distribution funds are not sex ‘n' violence funds, but nor are they twee and unassuming. If you are looking for a core UK equity holding to provide a stable foundation of a portfolio to which you add riskier investments in proportionately smaller amounts, then you could do worse than investigate distribution funds. Tracker Funds/ETFs There are some really awful - I mean truly awful - investment funds out there. Typically, a mere one in five fund managers beats the index they are benchmarking, whether it is the FT-SE 100 in the UK, or the S&P 500 in the US. In addition, there is another danger to watch out for - a sly and cowardly practice sometimes called benchmarking. This is where funds pretend they are actively managed, and charge hefty management fees, but do little more than passively "track" their benchmark index up and down. This is cowardly, because the manager protects their back by avoiding risk, and it is sly, because they don't admit what they're up to. One such fund is the Halifax UK Growth, which lurks in the UK All Companies sector. Out of a sector with 264 funds with a five-year performance record, the Halifax UK Growth Fund is 194th. Over five years, this dog of a fund has returned 83 per cent when the sector average is 101 per cent and the best performing fund - Old Mutual UK Select - has returned 218 per cent. There is a huge risk implicit in this fund, and it's this: had you invested your money in a FTSE All Share tracker fund, you would have run the very real risk of making a much better return on your investments than had you invested in this sorry excuse of an investment fund. Halifax UK Growth fund charges its investors a 5 per cent initial charge and an annual management fee of 1.5 per cent. So why not shift your money to a proper tracker fund? You will pay no initial costs and annual charges from as low as 0.34 per cent. That may seem a small difference, but it can have a major impact on your final return. If you invest, say, this year's £7,000 annual ISA allowance in a fund charging 1.5 per cent a year, and that fund grows at 6 per cent annually for the next 10 years, you will emerge with £11,957, according to figures from Fitzrovia International, leaders in investment fund expenses research. However, if you had chosen a fund with an annual management fee of just 0.5 per cent, after 10 years you would have £13,140 - that is a mighty £1,183 more, even though the two funds grew at the same rate. Moreover, the longer you keep your money invested, the more those savings stack up. After 20 years, you will have £20,424 with the higher-charging fund, but £24,666 with the cheaper fund - £4,242 more. That little piece of small print has cost you a lot of money. In fact, you will do even worse, as closet trackers also hit you with an initial fee of around 5 per cent, so your initial investment will be closer to £6,650 rather than £7,000. Trackers work best as a core holding in your portfolio, giving you a good spread of different companies, sectors and markets. They work especially well in markets such as the US and UK, where so few active managers consistently beat the index. However, they do have drawbacks. One problem is that the most commonly tracked indices - the FTSE 100 and FTSE All Share - are increasingly dominated by a handful of giants such as BP, HSBC, Vodafone, Glaxo SmithKline, Shell and Barclays. The 10 largest UK companies total 50 per cent of the FTSE 100 and the top 20 make up 70 per cent - and almost 60 per cent of the FTSE All-Share. Therefore, any investor holding a tracker fund is more reliant than ever on these top 10 stocks, which the fund has to hold, regardless of their prospects for future growth. So with trackers, there are only two main points to consider: the index the tracker tracks and the charges the fund levies - the lower the charges, the more money you'll make because more of your money buys units in the fund. Index trackers are commodity products and should be bought primarily on price. Credit Suisse, Direct line, HSBC, Marks & Spencer and Virgin Direct all charge one per cent on their FTSE 100 trackers, and we've already seen how small differences in annual fees cost you dearly over time. Since trackers do exactly the same - passively follow their chosen index up or down - there is no reason to pay more. Simply find the cheapest you can. Fitzrovia measures the entire cost of investing with a total expense ratio (TER). The ratio takes into account other costs of running fund not included in the annual fee. Fitzrovia says the cheapest trackers are Abbey National Stockmarket 100 Tracker Growth (0.35%), F&C FTSE All-Share Tracker (0.35%), Liontrust Top 100 (0.39%), M&G (0.49%). Fidelity says its tracker TER is now the lowest on the market at 0.3%. However, these charges can change, so do some research before committing your cash. ETFs But there's another, less well-known type of tracker, called exchange traded funds (ETFs). Experience investors might find these have the edge. ETFs are index trackers that are bought and sold on the stock exchange like any other share. This means rates change continually as markets rise and fall, so you can time your entry into the market. Unit trusts, by comparison, are priced just once a day, so you don't know exactly how much you are paying. ETFs are so flexible because you can buy and sell ETFs in real time, they work best for more sophisticated investors who want to dip in and out of markets. For example, if you think an index is set to move sharply upwards, you could use an ETF to get rapid exposure to that market." When markets are moving quickly, this flexibility could make a notable difference to your return. iShares, from Barclays Global Investors, is the main provider of ETFs in the UK, allowing you to track around 20 indices, including the FTSE 100 and 250, the S&P 500 in the US, a range of European indices, plus Japan and China as well as commodities such as gold. ETFs are cheap to buy. They have no initial charges or exit fees, and annual management fees of between 0.2 per cent and 0.7 per cent. Most charge around 0.4 per cent. Unlike standard shares, you do not pay 0.5 per cent stamp duty when you trade. In the third and final part of this Special Report which will be out within the next few days, we will be looking at Multi-manager funds, Corporate Bond Funds and what many are saying is the investment management industry's New Big Thing - 130/30 funds
*The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not a guarantee of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice. |
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