Funds

The explosion in the number of Hedge Funds over the last decade is indicative of the desire by many, often very rich, investors to beat what might be called normal market returns.

Prior to the late Nineteen Fifties, in particular, before Harry Markowitz’ seminal work on Portfolio Selection, investing in shares was considered to be a risky and unquantifiable business, one of the main reasons why dividends then were usually higher than the return on Government Bonds.

Once it became possible to apply a bit of ‘science’ to risk and return and, in particular, the benefits of diversification became better understood, the stock markets became a more comfortable place for more investors.  Unfortunately, with the banning of insider dealing, improvements in corporate governance and the wider availability of high quality information, much of the mystique disappeared taking with it the prospect of excess returns.

This leant a huge helping hand to Hedge Funds who were able to market themselves on the basis of excess returns created by clever (at least in theory) financial models and leveraging.  The great advantage of leveraging is that if you expect a return of 10% and borrow ten times your original capital, that turns into a 100% return, very nice.  However, if you lose money with borrowings, you may find out that all of your capital is lost and you owe the bank money, not so nice.

Also, those running hedge funds were, in many cases, the cream of the financial world, particularly on the academic side.  Hedge funds gave plenty of scope to the highly intelligent to make money on the back of academic work.  In some cases, this level of applied IQ has been their downfall.  In physics, classical mechanics works very well in many practical applications and was good enough to land a rocket on the moon safely.  It breaks down completely at the margins, however.  In much the same way, many seemingly low risk ways of making a ton of money which were created by these boffins seem to break down spectacularly when faced with real world problems, particularly lack of liquidity.

So it is that Peleton, until last week a highly regarded British hedge fund, has found its strategies wanting.  In the process, it may be that investors will lose much if not all of their money in at least one of its funds.

You have to hand it to the old fashioned technique of buying a range of investments and sticking with it.  They may have dropped in value periodically but there was always the hope (born out in fact) that prices would recover with patience.

It may be that, for many, hedge funds will permanently have lost their lustre, as will any strategy promising to deliver excess returns for lower risk.  That is until the lessons of today have been forgotten, as they almost always are.

It seems that the inexorable rise in active management charges continues.  Fund data researchers Lipper have published their annual survey of fund management charges and their findings are depressingly familiar.  Total Expense Ratios (TERs) have increased from 1.52% per annum in 2003 to 1.61% last year meaning that the fund managers are taking a bigger cut of a pot which has grown considerably in size.  Would this be tolerated in any other sector?  We do not seem to be showing clothing retailers the same tolerance for profiteering, quite the opposite.  These companies seem not be passing on the benefits of economies of scale.

The liberties taken with charges seem even more iniquitous when you stop to consider that most of these funds are underperforming their relevant index, for example, the FTSE Allshare and many incur huge costs which are not even included in the TER because reporting requirements in the UK allow managers to conceal many of the costs their trusting investors are bearing.  Do remember that many of these funds will have charged 5% on the way in as well.

Thankfully, investors have some choice.  Many will forego the smoke and mirrors of active management and construct their portfolio from low cost index trackers with no, or very low, upfront fees either doing it themselves or finding advisers who have not bought the active funds’ sales pitch.

It seems that the woes of New Star, the high profile new boy on the fund management block, worsen by the day.  It seems like only yesterday, or last year, that New Star could do no wrong. Their right ups in the Press were glowing and public and advisers alike rushed into their well performing funds.  Now, its funds languish at the bottom of performance tables, managers are reshuffled between funds and its shares disappoint.

This is neither the time nor the place to analyse the exact reasons for New Star’s travails, which may be short lived, but there are lessons to be learnt from their fall from grace.

Out performance of the market can only come through either manager skill or manager luck.  As with Napoleon’s generals, it seems that it is better to be lucky in the fund manager world.  Manager skill is notoriously difficult to isolate and the marketing machine puts a lot of effort into persuading that positive results stem from skill rather than luck.  This, it seems, plays into the hands of much of the public and their advisers because there is comfort in believing that the person managing your money has a special skill.  In order to outperform the market, a manager must make bets by holding investments in a way which are different to their weighting in the market.  I do not think much of granny’s money would wing its way into a fund were the advertising emphasised that the manager had been very lucky with his bets of late.  No, what the public seek is skill, any sap can be lucky.  Skill is worth paying for, luck is not.

The problem with luck is that it turns.  It also cannot be engineered, it is all down to chance.  So, if stellar performance turns out merely to have been luck, as it usually is, there is nothing for it but to await its return.

None of which brings any comfort to those who bought into the skill story only to find it was down to luck.  Someday, perhaps, investment management groups will have to warn investors that any outperformance can only be attributed to luck.  Another reason to stick to tracker funds.

If you are the type of investor who habitually chases last year’s performance, you will, no doubt, be about to commit a significant proportion of your portfolio to Emerging Markets.  The MSCI Emerging Markets Index was up 35% last year (so long as you measure your wealth in dollars, that is) and has quadrupled investors’ money over the last five years.  With Commercial Property out of favour and Equities in Developed Markets seemingly dogged by uncertainty (is there ever much certainty about the future?), history would suggest that money will be heaped upon those sectors which can show a strong recent showing.  The question for rational investors is whether this makes sense.

There are two ways of trying to answer this, although both are unlikely to be truly accurate.  Firstly, we can fall back on analysis of the fundamentals, e.g., comparison to historic valuations or economic outlook, knowing of course that life is rarely that simple.  Secondly, we can apply the coin flippers technique and wonder whether we can throw heads yet again.  This is not the place to broaden the discussion into statistics but it would be wise to consider how likely the Emerging Markets sector is to do so well over the next five years.

Most of us, however, will simply place our belief in diversification, happy with the comfort it brings and secure in the knowledge that we do not have all our eggs in one basket.  If you have a hunch about the coming year, it might not hurt to punt a very small amount on it, if only for interest.

If your investment manager does not share the same timescales as you, can they really deliver the performance you need?  When the tenures of fund managers are measured in months rather than years, it is no surprise that their strategies do not suit investors, for whom investment horizons may be measured in decades.

It is important for investors to realistic about the investment objectives set by their fund manager who is much more likely to be focused on their CV than most investors would believe.  To the average fund manager, an above average return every three years delivers headline grabbing performance for long enough to draw in more funds and to enable them to feather their nest; that career move will leave most of their investors way behind.  However, a good year followed by a couple of poor years does not give them the type of consistency most of them seek, however well it is marketed.

It is certainly worth being a little cynical when assessing the suitability of a fund or investment management service as moral can be sapped in the face of personnel turnover, often bottom of the list of selection criteria.

I know it makes me sound like an old duffer but I am sure fashions come and go quicker these days.

The latest must have investment accessory is the Inverted Index Fund.  These return the opposite of the index and allow investors a way of shorting.  There are not many ways for private investors to take advantage of a belief than an index (or other investment) will go down in value, other than not investing in it, so some will welcome there arrival.  A number of fund groups are scheduling launches, almost certainly in equities and commodities so watch this space.

Whether there is a place for these in the portfolio of a long term investor, I am not so sure, but they are certainly of interest.  Technically, many things are becoming possible and I am sure we have only just seen the start of much innovation but as investors we shall need to be careful not to be sucked into the hype.

If, however, you have been waiting for a simple tool to allow you to make money (we hope) from shorting, it may be that your waiting days will end soon.

Is there any end to the pain endured by holders of With Profits funds and policies?  The relentless downward spiral of these once great investments is a sad indictment of the way insurance companies have treated their policy holders over the last twenty years and they (by which I mean WP funds but it could apply to the insurance companies) seem to be in terminal decline.  The inherent lack of transparency and flexibility of With Profits funds have left them struggling for relevance in the modern world and with the possibility looming that the regulator will turn off the commissions tap, there seems little left to sustain them.  Unloved and misunderstood by most, we should not mourn their passing.

Below is a graph showing the history of annual bonuses awarded to the ever suffering investors by a 'leading' insurance company.  Not a pretty sight.

Zombie Funds, so called because the money in them is living in a dead fund, have been hitting the business headlines of late.  In particular, Resolution Life has become the subject of a tug of love between Pearl and Standard Life.  For millions of savers this is of more than a apssing interest because Resolution takes care of many billions of pounds of their money and is itself worth more than £2bn.

Resolution was formed as an acquisition vehicle for funds lying in closed life funds with insurers such as the Royal and Sun Alliance.  These companies had decided that they would be better off getting out of the business of running pension and life funds and simply shut up shop.  Having decided to abandon their many policy holders they then sold off the funds to save them the bother of running them and dealing with disappointed investors.

Whether I would be happy with my life savings being in a Zombie Fund is a moot point, it hard enough keeping track of who exactly is running this unloved pot of cash, let alone being sure they are acting in your interests.  Whoever owns it, it seems to be more profitable than being an investor.

Investing in commodities, by which, it is normally meant the raw materials for industry such as minerals mined, metals refined or agricultural produce, presents a number of practical obstacles.  Private investors can hardly take delivery of several tons of wheat, for example.  

Traditionally, institutions have made money from the commodities markets by trading in forward contracts, futures and options.  These markets are notoriously difficult territory for smaller investors and not generally appropriate for a long term strategy of buy and hold.

So why the interest in commodities?  Well, they can provide the opportunity of an uncorrelated return to add to an investment portfolio, i.e., they do not go up and down at the same time as equity markets much of the time.  Diversification is central to portfolio construction and the search is always on for assets which increase this.  However, as everyone rushes to diversify, assets can start to become correlated.  That said, there is still a case for the inclusion of commodities, even though they have no income generating prospects, important to many investors.

Most will obtain some interest in the commodity markets by investing in companies which derive their earnings from producing them, mining stocks, etc.  Now, however, there are increasing numbers of Exchange Traded Funds (marketed as Exchange Traded Commodities, ETCs) linked to commodities indices.  These give the opportunity to access returns on a broad range of commodities from platinum to oil to livestock and are worthy of consideration for inclusion in a well diversified portfolio for the long haul.

For at least the last three years, actively-managed funds investing in Japan have failed to perform, with the IMA sector average returning 15.1% compared to the MSCI Japan Index, which grew by 35.3%.  Oddly enough, Japan is one of those markets where funds managers seem most stridently to believe active management, rather than index tracking, is important.  One well known management group even managed to lose 44.3% for its investors over the last three years.  Still, the mis-placed confidence of fund managers to deliver out performance is unlikely to be diminished; that would be awkward for their marketing departments and career damaging.  Sales of funds to the public are heavily dependent on optimistic pronouncements about the future and hints of a magic formula delivering exceptional performance.

The rise of ETFs seems to be inexorable and this year, though fraught with difficulties for investors, may see record inflows.  Although they are much used and appreciated by many institutional investors and the more sophisticated financial advisory firms, they are yet to make significant inroads into the retail market.

There are a number of reasons for this:

Firstly, not everyone is sure what an ETF, or Exchange Traded Fund is.  Most investors are familiar with collective investments, such as Unit Trusts and OEICs (Mutual Funs in the US), which are pretty much the same thing, and Investment Companies, as Investment Trusts are now labelled.  These pool investors cash to buy a portfolio of investments sharing out the returns and losses.  Unit Trusts can be purchased directly from the managers or through the many platforms and fund supermarkets now available and most are priced once a day to reflect changes in value.  Investment Companies, on the other hand, are listed on the Stock Exchange and bought through a Stock Broker.  Their price may fluctuate during the day to reflect market sentiment, i.e., they are priced in 'real time'.  ETFs are very much the same as Investment Companies with a couple of differences.  Most, if not all, are not actively managed and simply track an index.  They also have no gearing and do not trade at a significant discount or premium to the value of the underlying assets, i.e., they aim to reflect the true value of the relevant index at any given time, and they are priced in real time. They often have lower annual charges than the equivalent Unit Trust Tracker Fund and most launches of Trackers these days are in the form of ETFs.

The second reason why they are less familiar to retail investors is that many of the popular fund supermarkets do not promote them.  ETFs are not designed to offer the fat commissions that Collectives have inbuilt.  This nice commission enables many of the well known supermarkets to offer 'free' switching and attractive 'discounts' to customers.  They can also bundle extras like a 'free' SIPP (Self Invested Personal Pension).  These platforms are often marketed heavily, indeed, they provide the back bone of comment and analysis in the Sunday Papers, and it is hardly in their interests to encourage too much transparency.

However, the word is out and something like $14bn of investors money will find its way into these funds globally this year.  Expect to hear even more about them in the future.