Fund Selection – Philosophy & Process

Recently I read an article in a trade paper that I subscribe to called Money Marketing. It was about IFAs’ research and due diligence in fund selection, or lack of it. Like much of what I read from the regulator and financial journalists (Paul Lewis from Moneybox has a weekly column in the paper) it highlighted the short comings of advisers. With the front cover posing the question, “Are advisers doing their homework on fund selection?” and the article itself entitled, “Fears grow over advisers’ investment due diligence,” it was clear IFAs were going to come in for criticism.

The article highlighted too much reliance on ratings agencies, shallow research and a lack of allocation to low cost passive index tracking funds. One commentator argued that fees are the one thing that advisers can control when they select funds and went on to say that it is difficult to justify why advisers still recommend active funds. He could have been criticizing me as I have an instinctive preference for conviction led actively managed funds.

Survey results were cited and few IFAs considered portfolio turnover important or very important. This observation follows the same theme, after all turnover is another fund cost. Other factors deemed essential in research were fund size, fund manager tenure, investment company brand and investment processes. Finally a lack of IFA firms having investment committees and meeting fund managers was also highlighted.

Naturally the article got me thinking about how I go about researching and selecting funds. I was left feeling that the thrust of the article did not accord with my own philosophy and practice and missed key high level considerations that I consider essential, so I penned a letter to the editor to explain how I go about it. The letter was published the following week in Money Marketing. It then occurred to me I couldn’t recall writing an investment blog about the subject. The following is an edited version of my letter that hopefully gives you a flavour on how I go about fund research i.e. my philosophy and process.

Whilst your recent article about IFA fund selection research made some good points it did not accord with my experience and reality. Firstly the observation about the dearth of advisers with investment committees and personal meetings with fund managers may be valid in large practices but it is a different world for me as a one man band and I suspect most very small firms. We lack the resources for investment committees and the clout to warrant audiences with fund managers. Interestingly I do occasionally get the opportunity to talk to fund managers at seminars or webinars but it is rare and they are not available to me at my beck and call.

I also query Mick McAteer’s belief (he is from the Financial Inclusion Centre) that the key determinant of fund selection should be low costs, based on the principle that fees are the only certainty. The implication is passives and index trackers should be the default choice at all times. In my experience differences in fund performance are far more significant than differences in charges, meaning investment process and potential is most important. However my main objection here is that evidence suggests that index trackers perform poorly compared to active funds in falling, volatile and sideways moving markets. Where I have used index trackers successfully is when advising clients to buy in at market troughs. The point here is that fund selection needs to be in the context of where we are in the stock market cycle not divorced from it. For example I would be very wary of recommending a FTSE 100 or S&P 500 index tracker right now for obvious reasons.

Another key point for me is that fund selection and asset allocation are inextricably linked. I can’t recall asset allocation being highlighted in your article. I subscribe to the view as many investors do that asset allocation is the single most important determinant of investment returns. There are assets I favour, those I don’t; equity regions I like, those I don’t and investment styles I prefer and those I don’t. My choice of fund in part is determined by how close a fund’s investment style and asset allocation accords with own investment convictions. To sharpen and express these beliefs I write an investment blog published on my website.

Whilst consideration of charges, turnover rates, active share, fund size etc. have value, a principle factor for me in investment choice is that I buy fund managers as much as I do funds. I spend a lot of time listening to webinars and reading fund manager commentaries. I am attracted to managers with clear and compelling investment processes backed by strong evidence and logic. Often but not always these are contrarians with out of the box thinking. Whilst my fund selection must be rooted in objectivity, fact and logic I see an emotional or even artistic dimension to my fund choices. Writing blogs ensures I can explain these beliefs which I consider an important element of my due diligence process.

In addition my fund selection process is driven by a belief that I go from client to product or fund, not the other way around. In other words it is a client’s objectives, needs and existing portfolio that largely determines fund selection. For example one client of mine has an absolute no animal testing requirement for her portfolio. That rules out 75% of funds that even have an ethical label. Index trackers may be ruled out automatically for cautious risk investors when equity markets have peaked as at present. Investment in adventurous risk funds may be appropriate for long term investors or regular savers even if they are cautious risk clients and the balance of their portfolio reflects that profile.

Finally there is an important practical implication of research being client focused for advisers like me who charge on a time cost basis. I could shortlist five funds for a more detailed assessment including meetings with fund managers but who am I going to charge my time to? Logically if it is individual work for a client it is the client who should pay. I do not think my clients will be happy to pay lawyer scale mega-charges if I billed them for 10-15 hours work on detailed “due diligence” on these five funds on top of everything else. My choice of fee structure requires me to work efficiently and smart, not to perfection, that a fixed fee could demand. If fund fees are important for clients so are adviser charges for research and I try to keep these to a minimum.

In conclusion I see high level research i.e. considerations such as a fund’s asset allocation, fund manager convictions and client needs as being much more important than the nitty gritty of fund details such as portfolio turnover, Beta* or annual management charges. The former list screens out a vast number of funds. Once the basics are established I try not to spend too much time on getting perfect specific fund choices as I see a search for perfection is subject to the law of diminishing of returns.

It would be unfair if I did not state that I don’t always get fund selection right. At times I get it spectacularly wrong and recommend investments that turn out to be dogs. This is why balanced portfolios need to constructed with diverse and complementary fund holdings. It is the same principle of spreading risk when managers buy 50-100 stocks for their funds. It is also why investment reviews are crucial. Holding a bad fund for too long is a drag on portfolio returns and an unnecessary one at that.

*Beta is a common statistical measure of the expected return of a fund or stock in relation to an index. For example a Beta of 1.0 means a fund is expected to rise and fall as much as the market as a whole. A Beta of less than one means the fund is less volatile than the market and vice versa.

This blog post are my own views about fund selection. Nothing in this article should be construed as investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.