How to weigh up funds
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Deputy Editor
Tim Bennett Jul 30, 2010
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When it comes to picking a fund, one question matters more than most – should you aim to meet, or beat, the market? 'Passive', low-cost index trackers, such as exchange traded funds (ETFs), return the performance of an index (such as the FTSE 100) or other underlying asset, allowing for costs and a bit of tracking error. They don't try to offer more.
The alternative is to pay a fund manager to try to beat the market through 'active' stock picking. In theory, this should be a good bet. After all, your fund manager can winnow out the winners and ditch the chaff, rather than blindly buy everything in the index. And assuming a sufficiently flexible mandate, a smart manager should know when to get out of the market and reallocate your money into cash. Nice theory – sadly, according to a study quoted by the FT's John Authers, the evidence doesn't back it up.
Jane Li of BNP Paribas's FundQuest looked at 30,000 US equity funds managing $7,000bn between them. First she looked at 'beta' – the extent to which a fund rises or falls with the underlying market. A beta of above one means it tends to rise or fall by more than the market does, while a beta of below one means it tends to be less volatile than the market. A passive tracker should have a beta of almost exactly one, as when the market rises, say, 10%, the fund should track it. Then Li looked at 'alpha'. This is the value the manager adds to the fund. Positive alpha suggests the manager has done something special and generated returns above those that you'd expect.
Overall, equity funds have a beta of 0.93 – so most are heavily influenced by the market's direction. She also found that active managers tend to take more risk when times are bad. But sadly this does not lead to outperformance. In 2008, for example, equity funds had a beta of 1.01, so "they were overexposed to the market just as it collapsed".
As for alpha, looking at the past 30 years, "active managers had positive alpha in bull markets and negative alpha in bear markets". This is "the exact opposite of what clients might want" – sure, their fund managers got them a higher return in a rising market, but they exacerbated their losses in a falling one. And this poor showing isn't confined to major markets. In theory, fund managers should find it even easier to outperform in specialist areas, such as emerging-market stocks, which are often poorly researched and less 'efficient'. In reality, these markets actually saw the most negative alpha, suggesting that fund managers tend to get "suckered into the biggest prevailing trends of the moment".
Funds that generated positive alpha tended to have three key features: an experienced manager, low costs and low volatility. But finding these funds is tough, as there are relatively few of them. So "most investors should base themselves around index funds". Although "index funds are dumb", buying the actively managed equivalent is usually dumber.
Bag a spin-off
We're not fans of merger and acquisitions (M&A) generally speaking. It all sounds very exciting and generates lots of column inches in the press, but the deals rarely add much value for shareholders. You get the odd canny deal – Reckitt Benckiser looks to have timed its acquisition of SSL well and the deal makes strategic sense. But many more bids waste management time and corporate cash, as RBS's purchase of ABN Amro just before the credit crunch amply demonstrated. But can investors make money from the opposite strategy?
In a downturn, unwieldy giants – often struggling to make decent returns – demerge or spin off a chunk of their business. The biggest recent example was Cable & Wireless splitting into C&W Communications and C&W Worldwide. According to a study by accountants Deloitte & Touche, quoted in Investors Chronicle, there's money to be made here. In the ten-year period from 1998, "spin-offs gained 15% in the year after coming to market". Meanwhile, a separate study by Dr Thomas Kirchmaier of Manchester Business School found that, in the subsequent 769 trading days, spin-offs beat the market by 17.3%.
However, some sectors are better at it than others. The Deloitte study reveals that demergers in the financial services sector create much less value than those in technology and manufacturing. The two key factors that influence post-spin-off performance are the size of the demerger (smaller spin offs are better than big ones, often because the new, leaner business becomes a takeover target) and the length of time management commits to planning it (fire sales designed purely to raise cash fast rarely create much value).
So where should investors look? As Investors Chronicle's John Hughman notes, a spin-off of budget clothing retailer Primark (which boasts a loyal but "entirely different" customer base) from food producer Associated British Foods is worth watching. So is a possible demerger of the high street and travel units of WH Smith, given that chief executive Kate Swann "has turned to demergers in the past to unlock value".
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