ShareCrazy.com

By Martin Fagan

Welcome to the third, and final, part of this special report on investment funds, where we'll be looking at the convenience offered by multi-manager funds, the efficacy of corporate bond funds in your portfolio - and how they work - and we also look at what many are saying is the investment management industry's New Big Thing - 130/30 funds. These are long only funds that can go "short" and are the newest import from the USA.

Corporate Bond Funds

"Bond" is a word that has seemingly earned the trust of the public. Bonds sound safe, they sound secure, they sound as if they offer a form of financial protection; they imply a guarantee of sorts. Even though he stole the name from the author of a book on Caribbean birds, Ian Fleming thought James Bond was the perfect name for a British secret agent, as it implied trustworthiness, integrity, and reliability.

There is nothing wrong with corporate bond funds as a source of income, but to use them properly, you have to know not only how they work, but also the risks involved. The way corporate bond funds are packaged and marketed only adds to the confusion. Investors are lured in with high yields at the front of the deal, but are rarely made aware that, because corporate bond funds are managed to hit that high yield, you could face the possibility of your capital being fed back to you as income. Therefore, when you ask for your capital back, you could get back significantly less than you originally invested.

There are many reasons why the corporate bond market is booming but, as far as investors are concerned, the main attraction is the relatively low level of inflation. Inflation is the enemy of the bond investor, as it erodes the value of money. If a bond is paying seven per cent but inflation averages five per cent over the life of the bond, your inflation-adjusted return is two per cent. If the average inflation rate is three percent [on a bond paying seven per cent], then your real return is doubled to four percent."

Two other factors also add to the current attractiveness of bonds: a falling stock market and the threat of recession. There is also a third attraction to corporate bonds: the recent nationalisation of Northern Rock has been done to protect depositors - not shareholders, who may get nothing from the government in return for their shares. One of the biggest risks in corporate bonds is the risk of default, where the company that issued the bond fails to make the interest payment on the due date, or else goes bust and cannot pay the money back. However, credit ratings agency Moody's says 10 per cent of all bonds will default, which sounds a lot but, unlike investing in the company's shares, if you are holding the company's debt, you are in the queue for compensation. Typically, you will get between 30p and 40p in the pound back; this safety net does not apply to a company's shares as Northern Wreak shareholders will soon find out.

All companies issuing bonds are rated for their credit-worthiness by one of two hugely influential agencies: Moody's and Standard & Poor's. The higher the credit rating, the more financially secure the company, so the less risk is attached to buying its bonds, and the less they yield. Higher yields are paid on bonds issued by companies with lower credit ratings who have to pay higher returns in order to attract investors. Nevertheless, bonds can be re-rated for a multitude of reasons (the company is taken over by a financially weaker one; a company has an increase in cash flow making payment default even more unlikely). How a bond fund manager mixes up the various grades of bonds - and yields thereof - determines not only the income from the fund, but also its capital value.

If you ever pull the catch and peer under the bonnet of a corporate bond fund, you will see they all differ by subtle degrees as to what powers the income element. But the yield the fund is paying - and its name - is a good indicator to what sort of bonds is in the portfolio. A fund which consists of high quality bonds from credit-worthy issuers will yield around 6 to 6.5 per cent income. A fund that mixes high quality low-yield bonds with low quality bonds paying higher yields will pay between 7.5 to 8.5 per cent. A high-yield fund will pay more; in theory, the higher the yield on the fund, the riskier the bonds in the portfolio.

In theory? Well, that is because the risk of default has already been factored into corporate bond prices. You could ride the credit curve down to the bonds paying the biggest yields, but if these bonds are re-rated upwards, the prices [of the bonds] increase, the value of the portfolio increases so there is a chance of capital uplift. The argument has always been that by investing in riskier bonds you want your reward in the shape of a higher yield. However, there is an argument you are being overly compensated for what is, in practice, minimal risk.

As a general rule of thumb, the price of quality bonds (issued by companies like Tesco, Powergen, Halifax, et al) is 80 per cent sensitive to interest rate movements and 20 per cent sensitive to a credit re-rating. With bonds from less credit-worthy companies that pay higher yields, the ratio is changed around with the price sensitivity skewed to 80 per cent re-rating sensitive. In the high yield sector, because of the global credit crunch, most of the bonds have been re-rated downwards with any risk of default factored into the prices.

As well as credit ratings, the other major factor investors in corporate bond funds should be aware of is the all-important yield. Most corporate bond funds quote two separate yields figures: the running yield and redemption yield (also known as the yield to redemption). They sound similar but, in practice, are very different. The running yield is the income you receive from your capital taken in isolation; the redemption yield factors together both the income from your investment and the value of your capital if you were to cash in your units at that time. Both figures fluctuate daily.

If all that sounds like gobbledegook, then it is easily explained. Imagine you have £100,000 and you spend that buying a property with the sole intention of letting it out to tenants. They pay you an annual rent £10,000, or equivalent to 10 per cent of your capital. That rent is the running yield. If, after a year, you sell up, the redemption yield is the income from the property plus the value of the property minus any fees. If the property has risen in value by 10 per cent over that year and you had an income of 10 per cent then your redemption yield would be 20 per cent. Set against a running yield (the rental income) of 10 per cent, this is a good deal: you have income and capital appreciation

However, if the property had fallen in value by 10 per cent, this cancels out the income. Therefore, although your running yield is 10 per cent, because of the equivalent fall in the value of your capital, the redemption yield would also be 10 per cent. In short, you got your income and, although no capital growth, no capital erosion either. If the running yield is higher than the redemption yield, then you are getting your capital fed back to you as income, which is eroding your capital.

Moreover, this is your biggest indication that, although you are in receipt of income, your capital is being eroded away. The smaller the gap between the two figures, the less of your capital is being eaten away. In addition, the level of income quoted is neither fixed nor guaranteed, which is a mistake many investors - even sophisticated ones - make.

Also, it is vital to know which element - yield or capital - the annual management fee is coming from. The average fee is 1.25 per cent, but some funds take it out of the income and some take it out of the capital. If it is taken from capital, the yield is unaffected, but it is another element that erodes your investment. Better to invest in a fund that takes its fee from the yield. You get less income, but also less capital erosion.

These may sound like high charges but, like all investment funds, one of the aspects the fees cover is diversification. Diversification absorbs risk and a fund actively managed by experts reduces risk even further. Moreover, a corporate bond only pays out twice a year, whereas a fund will pay out every month, if that is what the investor requires.

So if you are in the market for a corporate bond fund, for what should you look? The first thing is that the performance of a corporate bond fund is rated with the income reinvested, not with the income stripped out. Fine, if you are looking to reinvest the income, but a fact to bear in mind if you're taking the income. Look for a fund that charges next to nothing to get your money in and that charges no more than 1.25 per cent a year annual management fee and where that fee is taken, either capital or (preferably) yield. Moreover, make sure the difference between the running yield is lower than the yield to redemption, which means not only are you getting income, but also capital appreciation as well.

Here are some corporate bond funds worth bearing in mind. INVESCO PERPETUAL Corporate Bond has a running yield of 4.91 per cent and a redemption yield of 5.28 per cent and its recent performance has been helped further by not having exposure to the troubled US sub prime mortgage market. The M & G Strategic Corporate Bond fund has been positioned with an emphasis on higher rated bonds so it yields less than a fund investing in bonds with lower credit ratings. Currently, its running yield is 3.98% and a redemption yield of 4.00%

The Aegon Investment Grade Bond fund mainly invests in reasonably high quality bonds issued by well-established UK companies. However, it should be noted that its gross running yield is 5.87% and its gross redemption yield is slightly lower at 5.84% so what you gain in income you lose in capital appreciation. Earlier this year, the manager of the New Star Sterling Bond fund, Phil Roantree, had a relatively high exposure to the gilt market as felt that confidence in the bond market was waning. This proved to be the right strategy as there was a flight to quality. However, it is a similar story as the Aegon fund as the Gross running yield 5.02% and a Gross redemption yield of 4.99%

Remember to bear in mind that this is less of a problem if you are reinvesting the income back into the fund to buy more units. But if you're taking the income, it will chip away at you capital

Multi-Manager/Funds of Funds

So old they are new again: multi-manager, funds of funds - whatever you call them - are now all the rage, with a number of investment houses launching rafts of new products. There are many advantages in going down this route with your investments, as some funds of funds are managed by incredibly good managers. Also, if you have a rag-bag bunch of an investment portfolio, funds of funds are a good way to tidy them up and give your portfolio a cohesion it might otherwise lack.

Fund of funds are investment funds that are built using other investment funds as the building blocks. Relatively easy to establish, they have proven increasingly popular in the UK and Europe over the past few years. Prominent players in this part of the market include: AXA Multi-manager, Credit Suisse Asset Management, Edinburgh Fund Management, Henderson Multi-managers, Jupiter and Skandia.

The fund of funds approach is based on the belief that no single fund management company can excel in all areas of investment, and fund of funds can be either 'fettered' or 'unfettered'. Fettered refers to a fund that only invests in trusts or OEICs run by the same management group as the fund. Unfettered relates to a fund of funds that is not obligated to invest solely in internal funds, Solus being an example. As the multi-manager concept is based on diversity. For example, the Jupiter Merlin range of funds of funds can invest in any funds its management team deem suitable (although they also do occasionally invest in other Jupiter funds) while the Fidelity Wealthbuilder range invests only in other Fidelity funds.

As a rule of thumb, fettered fund of funds are not included in the Multi-manager universe, so if you are looking for a particular asset manager in the funds of funds tables and it is not there, chances are that manager runs fettered funds of funds.

When it comes to describing funds of funds, the analogy most used, to the point where it has become something of a cliché, is football. However, a cliché is merely a truth staled by repetition and, however much it's been used in the past, truly the best way to understand how a fund of funds works is by likening the individual funds in the portfolio to a team of football players from other clubs picked to play for an international team, say, England.

Just as Fabio Capello would never pick his England Team from one domestic club, nor does a fund of funds manager pick all his/her funds from a single asset manager. But finding the right combination of skills requires intensive research. Without the benefit of rigorous fund analysis, the odds are stacked against the average investor or even the intermediary, such as an IFA. On a practical level, the multi-manager approach puts a dream team within the reach of ordinary investors, bringing together the best investment management skills from around the world and blending them to achieve a high level of diversification and returns that are consistent.

Just as success on the football pitch is not guaranteed simply by buying the best eleven players in the world, using a fund of funds theoretically ensures there's room to switch tactics swiftly as the opposition changes during the season. If any funds disappoint relative to expectation, their existence in the squad will be questioned. And if a manager believes the economic outlook will favour certain types of funds, like football players, that manager will buy more of those and perhaps sell ones they believe might be adversely affected.

Researching and selecting the funds is a rigorous affair, with a huge number of factors determining which funds make the 'team'. Below is a graphic of the Credit Suisse selection process works. Its a few years old, but it gives you an idea of the inverted pyramid sieving system/process that many asset managers use to sift investment funds to find the ones that best suit their purpose and investment objectives.

Most fund of funds managers agree you need a spread of talent to make a successful team - rather than picking a team of strikers, you need a goalkeeper and a defence to stop you conceding goals, as well as a midfield and strikers to help you score them. For example, with European funds, a manager might want a growth fund; a value fund and perhaps a fund that takes a more pragmatic approach by just picking what it believes are the best companies. A fund of funds manager seeks to cover every eventuality, in both bull and bear markets.

Because multi-managers invest millions of pounds in funds, they are courted heavily by the fund management industry, getting access to information that the average private investor could only dream of. They would expect to get, for example, a complete monthly breakdown of how the fund is constructed that simply is not available to private investors. They can also just ring up a fund manager and interview them about their holdings as and when it suits them. In addition, if a fund manager ups sticks and moves to a rival firm, you can bet your bottom dollar the multi-managers will find out well before the rest of the world.

This puts multi-managers in a privileged position and means they are often able to spot a fund that is likely to suffer a bout of poor performance well ahead of the rest of us.

Another advantage in the multi-managers' favour is their ability to buy funds private investors would not be able to access. In the past decade a number of top fund managers have left major investment houses such as M&G and Barings to set up their own boutique operations in order to run money in the way they, rather than their bosses, see fit.

Some of these managers, such as Crispin Odey, who left Barings to run the highly successful Odey Continental European fund, have opened up their doors to private investors. But many others, such as the highly respected Thames River, have decided that they don't want the expense of marketing to the retail investor (ie, you and me) and so discourage them by imposing high minimum investment levels of £10,000 or more and basing their funds offshore.

Nevertheless, these are not significant hurdles for the multi-managers. They are often investing millions of pounds at a time and so are courted as much by the boutique groups as by the larger investment houses. Some of them have such strong relationships that they are able to invest in funds even after they have closed to new business. Jupiter's Merlin range of funds of funds can invest in the Findlay Park American fund, even though that particular fund is no longer taking money from new investors.

However, the critics of funds of funds point out these funds come with a double layer of charges - one from the underlying funds and the other from the firm managing the fund of fund. The irony is the biggest critics of the double charging were IFAs, who felt such funds are costly; and that picking a range of funds for a client was their job. Nonetheless, more and more IFAs are putting their clients' money into funds of funds for one very simple reason: someone else does the research for them. The amount of research needed to efficiently run a managed portfolio service is growing, and many small IFAs thought it better to engage the services of a company that did this research as a matter of course, rather than trying to do it themselves. The average IFA practice has three registered advisers (although many are one-man-bands and several are huge) and these small firms of advisers cannot spare the time to research investment funds thoroughly.

So are funds of funds charges so punitive? Not really. Simply focusing on the extra charges on a fund of funds is missing the point. The average total expense ratio [TER] on a fund of funds is around 2.2 per cent, against a 'normal' fund's TER of 1.5 per cent. However, you get a lot for your extra 70 basis points of charging. Not only are you getting diversification and your investments monitored on your behalf by experts, but also the manager is buying in an out of funds at prices a lot lower than you would be charged as a private investor. If you cashed in one fund and bought another, it would cost you around seven per cent if you take into account the initial charge and the bid-offer spread on the units.

Research from IFA Bates Investment Services into funds of funds charges shows the average annual Total Expense Ratio levied is 2.06 per cent of your investment. The average initial charge was 4.56 per cent.

In return for paying slightly higher fees, a fund of funds manager worth his or her salt will give their investors (ie, you) exposure to funds that never really blip on the private investor's radar. And, conversely, put them into funds they will have heard of but might assume are lousy performers, such as LG Eastern fund or Thornhill Capital. Similarly, you may never consider Woolwich Corporate Bond fund a serious play, but the management of the fund is outsourced to Merrill Lynch; and, in terms of Far East investments, Prudential is a lot better than you might think.

So what do you get for your money? In two words: diversification and consistency. Funds of funds are a valid option for people looking for a core holding they do not have to worry about and who just don't want the anxiety of chopping and changing funds. Bear in mind there are around 900 shares listed on the London Stock Exchange, but the UK has over 2,000 investment funds. Many private investors really don't have the time, energy or facilities to research each of those funds and make a decision which ones to put money in. The fund manager does it for them.

As a mark of diversification, a fund of funds can hold bond funds and cash funds as well as equity funds. It can also diversify internationally and blend in a mix of investment styles and management companies. Each management company and individual fund manager will have a different way of doing things. They may be skewed towards growth or value investment styles; they may take a top-down or bottom-up approach to buying shares, they may invest in big companies or small companies. So a manager would construct a funds of funds by selecting the funds he/she thought were the best for my objectives.

The majority of investors only look at returns and performance, but often ignore risks. Multi-manager funds strike a balance between risk and reward with that major added advantage of diversification. You have access to the very best brains, which don't necessarily reside under one roof. These reduced risk profiles produce fairly consistent performance, and that's perhaps what investors should look for in a fund of funds.

Funds of funds will never be the best performer in terms of shooting the lights out. But they will always give consistent, above-average returns, and average is good, because most investors get below-average performance by default. The only drawback is, because of this consistency, they're not really suited to regular monthly saving, as their low volatility means the unit price doesn't fluctuate wildly from month to month. Or, to turn this on its head: if you have a lump sum to invest but worry the day you invest is the day before markets go south, the low volatility of funds of funds means this is unlikely.

All in all, funds of funds offer advantages and benefits to investors who want to invest, but don't want the hassle of chopping and changing funds to accord with market conditions or departing fund managers. For the amount of expertise you tap into at only a small additional cost, funds of funds are very good value. The key positive point is they're something you can buy and forget about. You don't have to anxiously read the runes to see what's about to happen in the markets, because the fund manager will hopefully see it coming and act accordingly. The performance won't be the best, nor will it be the worst, but you will get consistency. And perhaps, with Credit Suisse's Constellation Fund, which invests in aggressive growth funds from slightly obscure management companies, you might get a fund of funds that leaves more conventional growth funds choking on its dust.

130/30 funds

Like many industries, the investment management industry is always looking for the "Next Big Thing". Cynics could say the next big thing to part fools from their money, but that would be not only harsh, but also mainly untrue. Yes, there have been instances where fools have been parted from their money - leveraged equity bonds (the performance of which was guaranteed against a basket of stocks that included Marconi and Railtrack), split-capital investment trusts, with-profits endowment policies, and technology funds, especially those that came late to the party (Gartmore's Tech Tornado - launched almost on the day the technology bubble burst and known throughout it's very brief existence as the Gartmore Super Turdo fund - is the one that sticks in my mind)

But, at the retail end (funds they market to the private investor), fund management companies - and private investors - have always been lumbered with long-only funds, which are funds that have to physically own the stocks in the portfolio. If an investor wanted a fund that had the ability (and the authorization) to indulge in the black art of short selling then, if that investor didn't have the chunky buy-in price to a hedge fund (and find one that wouldn't be too sniffy to spurn him/her), a crash course in spread betting loomed.

So the fund management industry has lusted long to find a type of fund that can include the majority of "long" holdings but also have a tantalizing portion of the portfolio that was "short". Hitherto, the only type of fund that included an element of derivatives were "protected" funds when a portion of your investment (about 5p in every £1) was spent on options in order to hedge away any losses by putting a "floor" under the portfolio below which it wouldn't fall. But, with a bunch of asset management companies falling over themselves to launch "130/30" funds, that could all be about to change.

These types of investment funds, which have been described as "a long-only fund with a hedge fund stuck on top", have grown in popularity in the US recently and are now set to hit the radar screen of investors in the UK, with several fund groups promising launches in the coming months. So what are they and how do they work?

130/30 funds are similar to long-only funds to the extent that they build a portfolio as normal, allocating 100 per cent of assets (or net asset value, or NAV) to long positions. They differ, however, from traditional long-only portfolios to the extent they then short sell securities to the value of 30 per cent of NAV. The proceeds from the short sale are then used to acquire additional long positions, thereby bringing the total exposure to 130 per cent long and 30 per cent short. The 130/30 product provides market exposure (or "beta" - essentially market gains) but also enables the fund to generate additional "alpha" (the value the manager adds by beating the market) that wouldn't be available from mere stock picking nous.

The theory is 130/30 funds will outperform conventional funds by having more of the good parts while also profiting from identifying the bad. And, while they will obviously carry a bit more risk simply because the manager's bets in both directions are larger than for conventional funds, the fact that the bets are limited to 30 per cent means they should be less risky than full-blown hedge funds. Previously fund managers identified poor performing stocks simply to avoid them. However, managers of 130/30 funds can identify stocks they don't like as well as ones they do and bet on them accordingly.

So why are fund management companies suddenly falling over themselves to launch these funds? Well, it's all down to something called UCITS III. Basically, UCITS III concerns the management of investment funds and is two separate directives, but the one we're interested in is the Product Directive. This Directive has achieved two main objectives which has given fund management groups more latitude when developing funds: [1] The range of assets allowed as an investment for a UCITS scheme has expanded to include stocks, shares, cash, derivatives, other funds and a wider range of money market instruments and [2] These asset classes are permitted to be mixed in one fund.

But herein lies a conundrum. Like animals who have been confined in cages for so long that, when the cage doors are opened they're fearful of venturing out, so fund management companies seem wary of launching funds that take advantage of the new regulations afforded to them by UCITS III. Since UCITS III was adopted in 2002, some have argued that fund managers are permitted such flexibility that they risk launching funds without the capability to manage them correctly, while others worry that fund managers are not taking advantage of the UCITS III capabilities to the detriment of their investors. Even the FSA, who actually introduced and helped negotiate the rules, have also stepped in with worries over the extra freedoms now on offer.

So will these 130/30 funds benefit investors? Well, they have distinct advantages. Rather than a fund manager being only able to invest in companies where they think share prices will go up, they haven't been able to speculate on share prices that might fall, which has been the domain of hedge funds. Instead of being able to make money on the downside, traditional long-only managers have had to move their money to a halfway house - cash - to protect against share price falls rather than using the potential to make money from those falls.

And this is where the advantages of a 130/30 fund would kick in. Rather than increasing his cash weighting, a fund manager constructs a typical long portfolio by picking what he believes are the most under priced stocks and also selects a short part for the same portfolio of what he believes are the most overpriced stocks. The long part of the portfolio acts like a typical equity fund where the manager aims to buy stocks that will outperform the market and deliver capital growth potential and the shorted overpriced stocks fall back and provide that "kicker" for the extra alpha in the fund's performance.

So few and far between are these funds - and so limited the current performance data - that you should look at the ones available to evaluate which is the right one for you. They only include F&C Enhanced Alpha UK Equity fund, the UBS US 130/30 Equity fund and the Threadneedle American Extended Alpha Fund. JPMorgan plans to launch four 130/30 products by the end of July (pending FSA approval), focusing on the European and US markets as well as a global fund. Other groups considering launching 130/30 funds include more offerings from F&C, UBS and Threadneedle, as well as proposed fund launches by Axa Rosenberg and Resolution, again later this year.

So these funds offer distinct advantages over long-only funds, but they're not without risk (the longs could go down and the shorts could go up). With only a few 130/30 funds yet launched and none of them having even a year's performance data, it's impossible to tell how these things will perform. However, they should be viewed as a genuine new development for retail investment funds and anything that offers informed investors more choice has to be welcomed, however cautiously.

*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.