Indexing

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.

For those holding cash, now could be a fantastic time to pick up some stock market investments at a knock down price, while some commodities (previously, the darling of investors)look overpriced.  Of course, it is perfectly possible that markets could drop further, after all, even if markets are efficient, they are not always rational.  At the moment, however, the stock markets, in particular, are volatile because investors are finding it hard to gauge the full extent of the sub-prime problem and its longer term impact on corporate profitability.

For those looking to hold investments for the long term, the FTSE100 looks a bit of a bargain at around 6300 when it has traded above 6700 only a matter of months ago.  The cautious, though, will be mindful of the fact that the index has yet to regain the heights of 1999 when it exceeded 6900.  It is always possible that we are in the early stages of a protracted bear market but many will find it hard to believe that the banks, even with all their problems, are as bad a profit prospect as their price would suggest.  Now, more than usual, we are seeing the benefits of diversifying.

For some investors, the January Sales have come early in the Stock Markets.

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.

It is quite likely that soon every conceivable investment niche will have been covered as Barclays has just launched an ETF tracking Timber and Forestry.  This fund will track the S&P Global Timber and Forestry Index and will come as a welcome relief by all those stressed by their lack of ability to do so.  Most, however, will not find their world rocked by this arrival but it does illustrate a trend, that of Alternative investments.

Alternatives, which include Hedge Funds and Private Equity as well as art and forestry, amongst others, have become much talked about in the last five years, or so.  Popularised by their successful inclusion in the influential Harvard Endowment Fund, they have spread out into many Wealth Management portfolios.  Their supposed benefit is high returns uncorrelated with equities.  There are one or two problems, though.  Firstly, as with all diversification, if everyone does it, the benefits of the diversification are reduced.  Secondly, any prospect for excess returns disappears when everyone piles in, certainly if you are not the first.  Harvard benefited enormously by getting in early and waiting for their imitators to pile in and drive up values.  Thirdly, what works for a multi-billion dollar fund with an indefinite timescale, may not work for those of us with fewer resources at our disposal.  Harvard went out and bought forests, not funds tracking the fortunes of forestry companies.  It is unlikely that forestry shares will exhibit the same characteristics in terms of returns and volatility as actual forests.

However, do not underestimate the power of marketing and investors desire to buy into a bandwagon after it has left town.  That is not to say that their may not be a place for it, it is just wise to manage your expectations.  For those with deeper pockets, their are funds which give access to forestry ownership, albeit with higher costs than Barclays iShare levies; currently a modest 0.65% per annum.

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.