It is not unreasonable to assume that if a fund underperforms its benchmark and peers its manager is not doing a good job. While this is true in some cases, there are a number of factors other than this that can contribute to poor relative performance. And understanding these is an important part of the decision on whether or not to stick with a fund that has disappointed or to move on elsewhere, according to wealth adviser Bestinvest. And these reasons include the following, added Bestinvest.
■ Adviser remuneration
Part of the reason why such a large proportion of actively managed funds have under performed their benchmarks is because of costs that have nothing to do with the management of the portfolio: adviser commissions and distributor platform fees. The fund manager gets blamed for failing while the adviser gets commission for putting the client into the fund.
"Charges are a undoubtedly a factor in the overall picture of industry underperformance but as clean share classes eclipse traditional fund structures over the coming years, logically the ratio of managers outperforming should rise materially," said Jason Hollands, managing director at Bestinvest.
Read more on the scrapping of commission payments
■ The wrong macroeconomic decisions
A previously capable fund manager may get a big macroeconomic decision wrong, for example, backing a recovery that fails to emerge. You therefore need to decide whether their longer term record suggests this is a temporary blip and the position is recoverable.
■ Stock blow-ups
It can also be the case that an overall strategy is credible but a holding in a particular company goes horribly wrong for reasons that were difficult to predict. A recent example of this was BP (BP.): no amount of financial analysis could have forecast the oil leak in the Gulf of Mexico which sent its share price plummeting. At the time this was a popular holding in a number of UK equity income funds.
Read more on the effect BP had on equity income funds
■ Investment styles go in and out of fashion
A fund may go through a more prolonged period of poor performance because some have distinctive investment styles or approaches which can go through times when they are deeply out of step with prevailing market sentiment. For example, at the height of the dotcom bubble in 1999 markets rewarded fast growth companies even where valuations based on current earnings looked astronomical.
Fund managers who placed a strong emphasis on identifying cheap, undervalued companies underperformed but after the tech bubble burst the tables were turned. Switching out of value managers into growth funds at the peak of the bubble proved a very ill-timed move.
Notable examples include top manager Neil Woodford, who runs Invesco Perpetual Income and High Income (GB0033054015) funds. He avoided technology, media and telecoms in 1999 to 2000, and more recently lagged behind his equity income peers when cyclical shares rallied, despite his outstanding long-term returns (read more on this).
Read more on Mr Woodford's investment style
Other notable examples of so called contrarian investors include Fidelity's Anthony Bolton, who ran Fidelity Special Situations Fund (GB0003875100) and US investor Warren Buffett.
Read more on contrarian investors
Trading liquidity
The ability to buy and sell holdings (liquidity) issues and the drag impact of cash in a fund can hold back performance. For example, if a fund takes large positions in illiquid, small company stocks and the market enters a period of stress it may be difficult for a manager to buy and sell holdings, while valuations of companies can be affected by irrational pricing.
Also read about how cash drag affects property funds
Likewise, if a fund receives large amounts of new cash in a rapidly rising market this may provide a negative drag on performance as it may take time to invest. But if a fund sees significant redemptions then the manager may be required to liquidate key holdings at the wrong price.
For these reasons, Bestinvest cautions against making snap judgments on selling a fund which has underperformed. Investors Chronicle regularly features funds which have done badly in our ‘In The Doghouse’ column, based on analyst research such as Bestinvest's Spot The Dog and Chelsea Financial Services' RedZone.
Read our latest In The Doghouse report
But Mr Hollands stresses that it is important to remember that such research is not a list of funds that should be automatically sold, as it is not necessarily a guide to how the fund will do in the future. "You need to delve behind the headline numbers to understand what has gone on and whether the outlook is improved," said Mr Hollands. "That requires careful evaluation and isn't a decision that can be made on past numbers alone."
