The Financial Times has produced a Guide to Investing in Funds. I caught up with the author, Jérôme Lussan, to get some tips on how to assess funds and their managers.
Mr Lussan's main expertise is in assessing hedge funds, but he says there are plenty of things that self-directed investors can do to make better investment choices in the funds arena.
"Everyone has to be forewarned and sophisticated," he says. "Even if you have an adviser you can't entirely rely on them. There is always something we are not told and that's a huge concern for me. However, there are a few simple steps you can take to determine whether a fund is right for you."
He estimates it would take four or five hours to choose four or five funds. "That's not long," he says. "Look at how much you will spend in a shoe shop if you are so minded. You will drive 100 miles to get a better deal for a Volvo. But you don't do that for fund management. Fund selection is really fun - you can be straight away in Latin America. It's easier than direct shares."
He says you need to first put fund performance into context, comparing funds with others. "If the context shows it is best of breed you are on the right track," he says.
"Once you have identified a few (four or five) say, try to plot the monthly returns for each fund and see if the manager you are looking at is better than his or her peers. More importantly check to see how that manager coped with certain events of market stress where competitors may have done better or worse. All these are tremendously useful indicators of performance and uniqueness and give a real insight into the skills of the manager when it comes to the management of money.”
However, he recommends that you should also compare fund performance to a benchmark. For example, a UK all companies equity fund should be compared to returns from the FTSE All-Share index. “People will always try to sell you funds without context," he warns. "They will put the fund offered in the context of its fund peer group. But you could also compare it with returns from a World Equity index - that will cause you to think differently."
But he says you need to think about the history of the fund, too - for example, has the same manager been responsible for performance. "Some funds start with strong performance - that will skew returns forever but it may not catch your eye. A provider may launch 10 funds in one category and run with the successful one. Don't be fooled - they can twist the statistics."
While it is worth reading a fund's prospectus, he says realistically investors won't always look. Plus he warns that the prospectus is drawn up by lawyers in favour of the fund. "It's not in your favour," he says. "There are 'screw you' clauses. You can't fight every small print."
The description of the investment strategy, for example, tends to be quite flexible and open, so that the manager can, as much as possible, buy whatever assets he or she chooses. "This is helpful, of course," he says, "should the strategy need to be diversified or changed, but some investors would prefer to know what is going to be in the portfolio. The flexibility afforded by the prospectus also means that the manager can do as it sees fit and not be accountable to investors should the selected new assets prove to be risky and/or valueless over time."
So you need to check the fund's assets - you can usually find these in the fund's fact sheet. Most funds only specify the top 10 holdings but he says you could ask the fund manager if they will tell you more. "If you see something unusual then ask 'What is it?' Be more demanding and contact the asset managers."
He thinks that investors need to be more demanding of fund providers and managers otherwise the industry won't change for the better. "Cost is a huge problem," he says. "The industry is still overpaid. But there are very strong justifications for why it should be lower."
He also sees a problem with the transparency of information given to investors. "There's no rule on how quickly information about the fund must be given, for example," he says. "But any manager who doesn't provide clear and timely information is showing lack of business organisation. The same lack of information must exist in the compliance department."
Things that he says every fund manager should disclose are:
■ Standard deviation, which provides a precise measure of how a fund's returns have varied from the average over time.
■ Sharpe ratio, which uses a fund's standard deviation to measure its risk-adjusted returns.
■ Information ratio, which measures a portfolio manager's ability to generate excess returns relative to a benchmark, but also attempts to identify the consistency of the investor.
"We should have much better disclosure at all levels," he says.
