Safety in numbers

Anthony Bailey explains how to make sure you invest in the best funds run by the best managers

Investing in the stock market is not too difficult. Just contact a stockbroking or other share-dealing firm and buy some shares. But which shares to buy? That’s the tricky question – and it’s why only a minority of private investors buy shares directly.

Most prefer to spread the risk by investing in funds – unit trusts, OEICs (open-ended investments companies) and investment trusts – run by fund managers. These funds can invest in a range of shares and other assets, such as bonds and property. The different types of fund have different characteristics and legal structures. Most can be held in a tax-free ISA.

And investing in a fund-based Isa is easier than investing in shares. You can just cut out a coupon from an ad in a newspaper or ring up a freephone number.

But only a small number of funds are being advertised at any one time. There are literally thousands of funds on offer. Even if you know roughly what you want to invest in, there can still be scores of funds within a category of funds. For example, fund performance analyst Standard & Poors has 277 funds in its “Equity United Kingdom” sector. The average performing fund turned £1,000 into £1,126 over the 12 months to December 2004. But the best performer produced £1,341 – a cash gain of over two and a half times the average fund. Imagine the difference in cash terms if the top fund produced that level of outperformance over ten years.

Selecting the best fund for your investment objectives can be as daunting as picking individual shares. And it is highly unlikely that the same fund would top the charts year after year. So you have the further challenge of monitoring the progress of your chosen fund and deciding whether or not to switch to another fund at some stage.

A possible solution to the challenge may lie in the latest investment fashion – the multi-manager fund. Instead of picking one fund, you choose one manager whose job is to pick the funds that invest your money in shares. By opting to invest in a fund as opposed to investing directly in shares, you diversify and spread your risk. Using a multi-manager idea extends the principle. You diversify further by picking one manager to choose a range of managers on your behalf.
Two main types of fund fall in to the multi-manager family. First is the fund of funds. You invest in a fund that invests in other funds. Some funds of funds invest only in the in-house funds run by their own investment management firm. In the jargon, these are ‘fettered’ funds. But a single investment firm is unlikely to have all the best people. It may have made a name through a highly respected expert in the field of, say, large European companies or small UK companies but are its American or Far East specialists of the same calibre?

So there are now a growing number of ‘unfettered’ funds of funds. Some of your money may go into a fund run by ABC Investments, some in a fund run by XYZ Investments. All is invested through one overall fund of funds run by the multi-manager.

The unfettered fund of funds is what private investors are most likely to come across when using an ISA to follow the multi-manager route. The other type of multi-manager is the manager of managers. This has traditionally been the territory of big institutional investors such as pension funds.

Instead of investing in other funds, the multi-manager appoints managers from different firms to look after chunks of money in line with the style laid down by the multi-manager. For example, the multi-manager might appoint one manager to invest £50m cautiously in the top FT-SE 100 companies, another to invest £30m in small US companies.
The distinction may seem arcane, but here’s a practical example of it. Let’s say part of your chosen fund of funds is invested in a Smaller Companies UK fund. The multi-manager running the fund of funds may decide that there’s a more promising Smaller Companies UK fund to switch to. He sells the existing fund and puts the money in the other fund. By contrast, a manager of managers doesn’t have to switch funds. If he’s worried about the performance of the Smaller Companies UK chunk of money, he keeps the investments but sacks the manager and appoints a new one.

Different styles of multi-manager have their pros and cons. The ability to switch between funds gives the multi-manager flexibility: it can be done quickly. Having to appointing a new manager to look after existing investments can take time. On the other hand, there are costs in switching funds and the risk that money may be briefly out of the market (i.e. in the form of cash) at possibly a critical time while the switch takes place.

In practice, a few multi-managers use both styles. Some money will be placed in existing funds to be invested in line with the criteria set by the fund’s manager. Other money will be put under the control of a specifically appointed manager who will invest it according to the criteria laid down by the multi-manager.

You could be your own multi-manager. You could choose to put your money in several different funds within your Isa and switch between funds when you feel it is appropriate. That’s exactly what keen and active investors do. They follow the markets and monitor investment performance closely.

Passive investors, however, may prefer to pay someone else – such as a multi-manager – to look after their money. They save on time and paperwork and may lack the confidence to choose funds or to chop and change. But they do pay for the privilege, and the possible worry is that they pay twice. They pay both the charges levied by the manager of the fund of funds and the charges of the underlying funds.

These extra charges may be reduced because multi-managers deal with large amounts of money and can negotiate reductions on the fees charged by the funds they invest in. They may also get a rebate of the charge in the form of commission which can effectively be passed on to the private investor by way of lower charges.

A simple way of assessing and comparing charges on different funds is to ask about initial charges, annual management charges and (possibly) exit charges. But perhaps a more meaningful way of looking at the costs of investing it to find out the total expenses ratio (TER) which includes not only the direct charges but other costs a fund has. Comparing the TER, a multi-manager fund can work out at between 0.5 per cent and 1.5 per cent higher than other funds – though average costs on single funds can mask big variations.

Money that disappears in costs and charges will reduce your investment return – i.e. the money you have in hand when you come to cash in an investment. Even a small percentage can build up to a significant difference in what you get over many years.

Defenders of the multi-manager approach will say any extra cost is money well spent. What matters is the investment performance you get after charges. Paying someone constantly to check that your money is in the best place should improve returns. You are buying specialist investment expertise and – if the theory works out – the best people in different fields of investment. This should enhance your returns.

“There are few individual funds or investment managers that consistently add value” says Craig Heron of New Star, an investment firm that runs a number of multi-manager funds of funds. “Multi-manager funds should offer the potential for more consistent outperformance”. But does that mean that New Star regularly changes the funds in which it invests? “We run our funds in an active way – taking money out of some funds and putting it into new funds. Over a year we have a 100 per cent turnover rate”.

The multi-manager style of investment is still relatively new and it’s not yet possible to say whether it will give better investment returns. Judgement may have to wait until there have been a good handful of multi-manager funds with performance statistics covering five years – the minimum period normally to consider any kind of stock market investment.

It seems unlikely that multi-manager funds will give the best overall performance. For that, you usually have to take a high-risk punt on what is currently some out-of-favour area of investment. A multi-manager fund may be useful as a relatively safe core investment.

But even if you have decided against picking your own shares or individual funds, there’s still the task of picking the best multi-manager from a growing list. If you want to go it alone, look at the website run by fund information service Trustnet’s – www.trustnet.com. Trustnet has identified 132 multi-manager funds (excluding fettered funds) run by 31 investment groups: Abbey National, Aberdeen, Artemis, Axa, Capita, Cazenove, Credit Suisse, Edinburgh Fund Management, F & C, Fidelity, Gartmore, Global Asset Management, HSBC, Hargreaves Lansdowne, Henderson, IMS, Insight, Jupiter, Legal & General, Margetts, Marlborough, New Star, Premier Portfolio, Schroder, Scottish Widows, SEI, Solus, Skandia, T. Bailey, Unicorn, WAY.

Trustnet classifies the funds into four categories. Multi-manager UK funds invest at least 80 per cent of their assets in UK equities (12 funds of funds, 2 managers of managers)). Multi-manager Global funds invest at least 80 per cent of their assets in shares and no more than 80 per cent in UK assets (36 funds of funds, 3 managers of managers). Multi-manager Income & Bond funds invest at least 80 per cent of their assets in fixed interest stocks (19 funds of funds, 22 managers of managers). Multi-manager Managed funds invest in a range of UK and international shares and fixed interest assets (50 funds of funds, 4 managers of managers).

You can buy many multi-manager funds directly from the firms that run them. You can buy others only indirectly – through a fund supermarket or independent financial adviser. As with all investment funds, it’s often cheaper to buy indirectly.

If you need a helping hand, consider using an independent financial adviser. Some now accept that their investment expertise is limited. This didn’t seem to matter so much in the late 1990s. With stock markets booming all over the world, most funds would produce some positive return. Now it’s not so easy.

Tracking all the latest fund performance figures, the switching of the best fund managers from one firm to another, the merging of funds and changes in fees and objectives - it all takes a lot of effort and may not be the best way for financial advisers to use their time. And employing a dedicated team of fund researchers within a firm of financial advisers is expensive.

So some financial advisers are happy to pass the job on to multi-managers – who can monitor funds closely and interview fund managers to find out their methods. Financial advisers may do a better job of following the performance of a small number of multi-managers than the much larger universe of individual funds.

Meanwhile, they can concentrate their expertise on assessing and reviewing an individual investor’s needs, taking account of your goals, your expectations, your timescale, your plans, your attitude to taking risk – whether you are cautious or “aggressive” – and your tax position. They can establish your needs let investment experts select the best investments to meet those needs.

Bear in mind that the multi-manager style is a fashion and investment fashions can be dangerous. Some fashions are based on where to make money. Football clubs, bio-tech industries and dot.com companies have all been fashions in the relatively recent past – and all have left many fashion victims in their wake.

The multi-manager style is a fashion based on how to make money, or at least how to manage your wealth. It contrasts starkly with the how to fashion of five or ten years ago. This said paying expensive investment experts was a waste of money. You should keep investment costs down by investing in low-cost index-tracking funds. These funds require no research and simply buy shares in companies that make up a particular index, such as the FT-SE 100.

Which fashion is best? As an investor, you pay your money and make your choice. There is no surefire way of knowing in advance the best approach.