A colleague was recently telling me about his journey into the office and it was that dreaded moment when the warning light came on and he knew he’d have to try and work out what the problem was. It made me think that this is a similar way of thinking in relation to one of the biggest problems for the investor which is understanding what might be under the bonnet of the fund he or she is considering.
People who invest into actively managed funds do so in the hope that the management team will outperform the relevant benchmark by buying low and selling high over the years ahead.
Choosing that fund is no easy task. There are many funds in each sector and by definition at least half of them will perform below the average each year. Active funds also have higher charges when compared to passive equivalents which means they need to slightly outperform each year on average in order to be worth using at all. This is very difficult to do consistently.
Every fund group publishes key information and marketing materials for the fund they run. There are also many publicly available sources of data. Each fund is categorised within a sector and past performance can then be compared against peers. Therefore, why not select the fund with the best performance statistics over the past few years or choose a fund with a well-known name at the helm?
However, fund categories are wide – the risk levels at one end can be much higher than the other. Therefore, in benign conditions a ‘risk on’ fund will outperform less aggressive peers by focusing on the riskier end of the category. In rare cases it is a fine line between great management and arguably reckless behaviour. More risk means good returns when things go up but a bigger drop when they fall.
A liquidity mismatch is the ultimate issue here. Where a manager focuses on higher risk assets and also buys large percentage holdings in some of the underlying companies, they are creating a concentration of risk and it could produce an excellent result for the investor. The big bets have paid off and everyone is happy. On the other hand, if some of the bets go wrong and investors lose faith in the manager, they might become a forced seller of relatively illiquid assets meaning either the manager sells at a discount or suspends the fund to protect the value.
Such an outcome is very unusual in all sectors other than commercial property where the nature of property means liquidity can more easily become an issue. However, we have seen last week with the Woodford Equity Income Fund that it can happen in other sectors. I suspect that a lot of ordinary investors were unaware of the risk that his fund presented when they put their money in.
The key point is to understand the level of risk your investments really represent and then compare it to your capacity for loss. We are now 10 years out from the last big market event and investors may have started to forget that what goes up can also go down. The question is, by how much and could you afford to ride out a worst-case scenario. If not, you need to reconsider your approach.
This is a complex area, particularly if you hold the Woodford Equity Income Fund and are wondering what to do and that is why it is important for you to see guidance from your financial adviser. Just like my colleague who sought the help of the mechanics at the garage around the corner from here. Our team are on hand to do an in-depth review of your future plans and investment and help with any investment queries you may have so feel free to get in touch.