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The five step fund portfolio check

FEATURE: With £13bn of investors' money sitting in consistently underperforming funds, we show you how to conduct a fund portfolio check and how to work out which funds to dump

1 Relative performance

Past performance is not a guide to future returns but you should still look at the past performance of the fund and the fund manager. By looking at historical data, you can get an idea of the risk taken to generate the returns as well as whether the fund manager has exhibited skill or not.

IC TIP: Sell

Every month fund managers produce a fact sheet, which is usually available on their website. This shows you details of performance compared with the fund's benchmark, plus how the fund is performing in relation to its peers in the relevant Investment Management Association sector (or if it is an investment trust the Association of Investment Companies Sector). Both are useful indicators of how a fund shapes up.

Make sure that the benchmark is relevant. For example, a UK All Companies fund should be compared to the FTSE All-Share index, and an emerging markets fund to the MSCI Global Emerging Markets index.

However, time and time again, studies have shown that the majority of actively managed funds fail to beat their benchmark indexes, such as the FTSE All-Share. And managers who succeed in one year often fail the next, suggesting that many winning results are no more than luck. Giant index fund manager Vanguard has a vested interest in putting the case for index investing, but its research shows that only 22 per cent of the top-ranked funds over an initial five-year period remained in the top rank over the subsequent five-year period.

While you might be able to forgive a manager one bad year, consistent underperformance – ie, three years in a row – is more worrying. If this happens, look for another fund.

2 Performance relative to cash

It is all very well if a fund has performed well relative to its peers and the benchmark, but if these have both posted negative returns, leaving you nursing large losses, you might not be too thrilled. So you should also compare the fund's performance with what you would have got if you had held it in low-risk cash. If this makes you feel uncomfortable, then consider whether you should be holding your money in a fund at all.

3 Investment strategy

Make sure that you check the fund manager's factsheet for an idea of their investment strategy as this can help explain performance. You can expect some managers to perform better or worse in different market conditions. So check to see whether this has happened. But it is also important to look beyond past performance and get a view of how the manager sees the world. Is he a contrarian? Is he positioned defensively? This will mean that you know in what market conditions the fund manager is likely to do well, or badly.

4 Costs

Costs are so important because they are the only thing that you can control in investing. Find out the fund's total expense ratio (TER) – usually found on the factsheet – which is the best (although far from perfect) way to measure the cost of investing.

UK fund managers are much more expensive than fund managers in the US. The average actively managed equity fund in the UK has a total expense ratio of 1.6 per cent, taking £1.60 in charges for every £100 an investor has in the fund. That means the fund manager must beat the stock market's performance by 1.6 percentage points a year just to break even. If the market returned 7 per cent, the fund would have to return 8.6 per cent, a very large additional margin to achieve year after year. Put another way, if the fund manager selected investments that returned 7 per cent, his investors would receive just 5.4 per cent, or about 22 per cent less.

Can you find a cheaper fund that performs just as well? Could you consider moving some of your portfolio out of expensive actively managed funds and into cheaper passive funds?

5 Holdings

Weed out any closet index trackers – the top 10 holdings shown on the factsheet can be a good clue, revealing if the fund is offering access to sectors and shares that you would find difficult to access otherwise. If the holdings are very similar to the top 10 of the FTSE 100, for example, then why are you bothering investing in the fund?

Consolidate your core holdings in a tracker and then pick some actively managed funds that are really doing something different to the index.

Dog funds

Some investment advisers write annual exposés that showcase the funds that have failed to deliver returns to investors. It's not really surprising that these 'Dog funds' exist – with more than 1,600 open-ended funds available to UK investors, there's always going to be a few dud portfolios out there – but it is pretty alarming that there is so much money sitting in them.

Bestinvest's latest Dog fund study revealed that as much as £13.3bn of UK investors' money is floundering in funds that have underperformed their relevant sector benchmark by 10 per cent or more cumulatively over three years and underperformed the same benchmark in each of the last three years.

Unfortunately, despite the availability of better-performing funds, there appears to be little correlation between underperformance and the outflow of client money, according to discount broker Chelsea Financial Services' survey of dog funds called The Chelsea Relegation Zone. Take, for example, Prudential UK Growth; over the last two years to 31 December 2010 it underperformed its peer average by 9.51 per cent, yet it still managed to grow its assets under management by 47 per cent from £1,551bn to £2,278bn.

If you're in a dog fund such as this one, you need to vote with your feet and seek better opportunities elsewhere. Bear in mind that a 10 per cent loss on a fund will take an 11 per cent gain to get back to square one. If your fund underperforms its index by 10 per cent every year for three years, then it will take a 37 per cent gain to get back to the index level.

The Relegation Zone: The Dirty Dozen

RankLargest funds in the Relegation ZoneFund size
1stHalifax UK FTSE All Share IDX Tracker£2.329bn
2ndPrudential UK Growth£2.278bn
3rdHalifax International Growth£1.174bn
4thSwip Multimanager UK Equity Focus£1.174bn
5thScottish Widows European Growth£0.4888bn
6thInvesco Perpetual Income & Growth£0.461bn
RankWorst performers% negative deviation from sector average
1stUBS Absolute Return Bond58.24
2ndMFM TEchinvest Special Sits.46.11
3rdSVM Global Opportunities31.06
4thElite Henderson Rowe Dogs FTSE 10028.78
5thNewton Japan28.04
6thElite LJ Cautious Managed Portfolio21.48

Source: Chelsea Financial services, as at March 2011