By Nicos Cotsapas
Following last week’s article on funds to avoid, this week I will discuss what you should look for in finding the “best” funds. It’s important to note that seeking funds to invest in should only be done within the context of your overall asset allocation and risk profile.
Finding the best possible funds is a very subjective endeavour. There are companies like Morningstar, who rate funds according to a star system (1-5 stars) in order to help investors decide. One would think that by choosing only 5-star funds, the investments will do well. If only it were so simple.
Broadly speaking there are two types of funds. The first are so called “long-only” ones which benefit when the securities they are invested in go up, and are “benchmarked” to a particular index (for example a UK Equity fund might be benchmarked to the FTSE-100 index). The second are “absolute-return” funds which are by and large not benchmarked to any index and where the manager tries to make money in any market environment. Both types of funds have a place in one’s portfolio and I shall look at the two separately so that apples and oranges are not compared. Due to space constraints, this week I shall only refer to the former.
Long only funds
The main criterion in choosing a top long-only fund should be how well it is expected to perform against its benchmark. For better or worse, the only tangible information we have is its past performance, and therefore we are heavily dependent on analysing this. But there are other decisions to be made before that. In other words if one is looking for a broad European Equity Fund, one needs to first choose if they want a fund whose universe is the whole of Europe, Europe ex-UK or Euroland. Then they must choose between one that invests in large, medium or small companies, or a blend of all three. By way of example, let us choose the whole of “Europe Small Companies” universe, which is benchmarked to the MSCI Europe Small Cap Index.
If one looks to Morningstar for guidance (which is a good place to start), they will find 138 funds, of which 12 have five stars. Note that there are multiple classes of the same fund, which makes the universe seem larger than it is. Which is the best? Here are some questions that can help you decide:
Has it risen more than its benchmark on the way up and fallen less on the way down? This is the holy grail of what a top fund should do, and it is extremely rare for a fund to consistently achieve this. Yet, they exist.
What is your time horizon? If you had a one-year horizon at the end of 2012 and had, for example, chosen the 5-star Threadneedle Fund you might have been surprised a year later to find out that the “ordinary” 3-star Invesco Fund did much better, returning 36 per cent, or double Threadneedle’s 18 per cent return.
What class of fund are you buying? Make sure that you try and buy the lowest-cost class, and if possible (and if you have the means) the institutional class, that has the lowest expense ratio, which can make a huge difference in total returns over the years.
What is the currency risk you are taking? In our European example, if you are a euro investor and have chosen a fund that is heavily allocated to the UK, Switzerland and Sweden, you face currency risk if the euro appreciates against these currencies. Do not underestimate such risks. For example, if you had invested in the Australian market, which returned 20 per cent last year, as a Euro investor you would have actually lost one per cent.
Has the fund’s track record been achieved with the same manager or management team? Often a manager leaves and in cases where the fund is not managed by committee, which is often the case, the new manager might not reproduce the same results.
What is the fund’s size? If the fund is large, and as in the case above, it invests in the small company space, it might potentially face liquidity issues. It is important that a fund can exit its holdings quickly and without distorting the price.
Is there a bid/offer spread? Avoid any fund that charges more to buy than to sell.
Is an ETF (Exchange-Traded Fund) available that tracks the same index as the fund you want to buy? If so, is the index difficult to beat? Is the ETF liquid enough? If the answers to all three are “Yes” then opt for the ETF, which is a fund that is likely not to appear in the Morningstar ratings.
Has the fund been around for a reasonable amount of time (say three years)? This will eliminate any “luck” in its performance versus the benchmark.
Of course all of the above have a “rear-view mirror” factor, and the fine print (correctly) always reads “past performance is no guarantee of future returns”. Even betting on some “legends” of the fund industry like Bill Miller, Anthony Bolton and Bill Gross, you would have had significant disappointments along the way. So choosing the “best” is anything but easy…
Nicos Cotsapas is a partner of Cyprus-based Elgin AMC and Swiss-based Elgin Group LLC.
Opinions expressed in this article are those of the author and do not constitute financial advice in any way. Please visit www.elginamc.com for more information. If you would like further information on funds to buy or on how to structure diversified portfolios, please send an email to [email protected] or call 22-465104.