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Asking the right questions about funds

Our experts think that Kelvin Pretty needs to ask some questions about the risk factors within his portfolio of top-quality managed funds
November 29, 2011 and Mark Dampier

Kelvin Pretty is 66 and has been investing for 10 years. He wants to generate income and growth from a medium- to high-risk portfolio of managed funds, held within his own and his wife's individual savings accounts (Isas).

Reader Portfolio
Kelvin Pretty 66
Description

Isa portfolio

Objectives

Investment goal: income and growth from funds

KELVIN PRETTY'S ISA PORTFOLIO

Name of fundUnits heldPrice (p)Value (£)
Artemis Income Inc1,369149.892,051.99
Invesco Perpetual Monthly Income Plus Inc4,05593.37*3,786.15
JO Hambro UK Equity Income GBP Inc2,909116.0*3,432.62
Newton Global Higher Income996118.0*1,175.28
Troy Trojan Income O Acc610168.49*1,027.79
Schroder Managed Balanced H Acc4,05954.06*2,194.29
Jupiter Strategic Bond Acc1,45468.59997.29
Standard Life UK Smaller Companies R366265.3970.99
M&G Recovery A Acc3,551230.138,171.91
Jupiter European264802.742,119.23
BlackRock Gold & General A Acc1411,4982,112.18
First State Global Listed Infrastructure A Acc1,933100.641,945.37
TOTAL

£29,985.09

HIS WIFE'S ISA PORTFOLIO

Name of fundUnits heldPrice (p)Value £
Aberdeen Emerging Markets A Acc225468.681,054.53
Invesco Perpetual Income Acc1841,888.833,475.44
JO Hambro UK Equity Income GBP Inc2,7031163,135.48
M&G Recovery A Acc3,023230.136,956.82
Marlborough Special Situations206589.591,214.55
Schroder Managed Balanced H Acc2,15054.061,162.29
Schroder UK Alpha Plus Acc902110.91,000.31
TOTAL£17,999.42

Note: Price and value as at 23 November 2011.

Chris Dillow, Investors Chronicle's economist, says:

When you're investing in funds, there are two things to be aware of.

One is the danger that you'll fail to spread risk, and that your funds rise and fall together.

The problem here is that if a fund holds 50-plus stocks - as larger ones do - then the brute maths of diversification mean that it is inevitable that the fund will be highly correlated with the general market, unless it invests in specialist niches. This, in turn, means that funds will move in the same direction as each other.

My table shows that this is what's happened for your bigger holdings. All did badly in the year to November 2008, well in the subsequent two years, and poorly in the past 12 months. This is pretty much the same pattern as a tracker fund. There's not much diversification here.

Table: performance of selected unit trusts

FundYear to end-Nov 11Nov 10Nov 09Nov 08Nov 07
Artemis income-2.910.830.2-27.61.7
M&G Recovery-6.110.657.7-34.211.6
JO Hambro UK equity income-4.511.059.9-32.6-7.9
Invesco Perpetual monthly income plus-5.715.739.1-32.93.7
Schroder managed balanced-5.39.845.1-30.34.7
BlackRock gold and general -7.325.4136.9-45.937.2
Scottish Widows UK All-share tracker-5.711.844.7-37.72.0
Source: Trustnet

In one sense, this needn't be a problem. If you're happy to take lots of market risk - and this is ultimately a matter of taste - then maybe you'll like this.

But it is a problem in another sense. Actively managed funds charge higher fees than tracker funds. If you hold a lot of them, therefore, there's a danger that you simply get tracker fund performance but at a higher cost.

The second issue is that fund investors often ask the wrong question. They ask: does this manager have the skill to beat the market? This is the wrong question because alpha - genuine risk-adjusted outperformance - is often both small and temporary. Over the past five years, 155 of the 244 funds in Trustnet's database of all companies' unit trusts have underperformed the Scottish Widows All-Share tracker (I choose this not because it's been the best tracker, but because, arbitrarily, it's one I happen to own). And even if some fund managers do have skill, you might not have the skill to spot their skill.

Instead, the right question to ask is: what risk factors does this fund expose me to? This question reveals three things.

First, 'managed balanced' funds often look like tracker funds: note the similarity between Schroder's managed balanced fund and our tracker. This is because they have a high equity weighting - of 59.7 per cent at the moment in Schroders' case.

Second, BlackRock's Gold and General fund is a high-beta fund, not a gold fund; it has done very well in good times but underperformed in poor ones. This is because it owns mining shares rather than the metal itself - and gold shares behave more like shares than like gold.

Third, equity income funds can carry two different exposures. One is to cyclical stocks, which do badly if recession fears increase; this is consistent with JO Hambro's poor performance in 2007. The other is to defensives. This is because a high yield is often compensation for low expected long-term growth, which is a feature of many utilities and tobacco stocks.

Either or both of these exposures might be worth having. But the point is that it is exposures such as these, rather than fund managers' skill, that are the key issues in determining the attractiveness of funds.

Mark Dampier, head of research at Hargreaves Lansdown, says:

Your portfolio is full of top-quality names, although that is not to say that all the funds have fared well over the past year or so. Inevitably, the volatility of stock markets has meant that some funds have suffered.

Your objective is for an income and growth portfolio. In the past an income objective tends to move you into the UK market as it has been the traditional market for income. However, over the past few years, increasingly overseas markets have developed more of a dividend culture. As more and more countries have ageing populations, the demand for income has increased, while bank deposit rates have fallen sharply.

You hold Newton Global Higher Income. I would look to add to this. Newton also runs a very good Asian income fund too, which perhaps should be put on your watch list. With a second round of quantitative easing (QE2) already under way in the UK - and even the possibility of QE3 - sterling is likely to weaken further, which should add to currency gains made by investing overseas.

One fund that has suffered a setback this year is Junior Oils Trust. The fund invests in junior oil explorers, mostly profitable ones, yet they are perceived as being more risky by the market. With a 'risk off' attitude these have been driven down, in many cases by over 50 per cent. Yet the price of oil has not shown a dramatic drop. These oil companies are profitable with an oil price at $70 (£45.28) a barrel. So while it doesn't provide any income, this is a trust that could be bought on the weakness we are seeing at present.

Bonds have suffered as the eurozone crisis continues. The worries over sovereign debt and financial bonds have caused a contagion effect on other bonds. Your holding in the Invesco Perpetual Monthly Income Plus fund is heavily weighted towards financial bonds, hence its poorer performance. However, a resolution of the eurozone crisis would see this bounce back very strongly.

A different approach is taken by another of your funds, Jupiter Strategic Bond, which has a much more defensive portfolio, with little in financials and sovereign debt limited to Australia and Canada where the dynamics look far better. Generally speaking I think corporate bonds, particularly those lower-risk, high-yield ones, look particularly tempting and the M&G Optimal Income fund would be another holding to include, yielding 4.8 per cent.

I consider this a good-quality portfolio and believe that your patience will be rewarded in the end. Investors probably lose interest far too soon, particularly in such volatile markets, but good-quality fund managers usually see you right in the end. With names such as Tom Dobell managing M&G Recovery in your portfolio you should have little to fear in the long term.

Latest tradesWatchlist
Kelvin's last three tradesKelvin's watchlist
Jupiter Strategic BondBuyArtemis Strategic Assets
Troy IncomeBuyM&G Global Basics
Standard Life Smaller CompaniesBuyBlackRock European Dynamic