Seven questions to ask before buying a fund
By
Tim Price Oct 22, 2010
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Many long-cherished economic theories and investment assumptions have been put paid to by the financial crisis. The so-called efficient market hypothesis – which assumes, among other things, that investors are always rational and that markets are never wrong – has been among the more obvious casualties, as Alliance Bernstein's David X Martin makes clear in his new book, Risk and the Smart Investor (McGraw-Hill, 2010).
Risk tends to be the poor cousin to return in fund management marketing literature. But they are, of course, two sides of the same coin. In the two years following the collapse of Lehman Brothers, scores of books have claimed to identify the causes of the financial crisis and, in some cases, suggested remedies. Most offer little more than investment advice out of the rear-view mirror. Risk and the Smart Investor is a little different. Notwithstanding Martin's experience as risk officer at both AllianceBernstein and Citibank (before it went bananas), his advice here is free of cod-science posturing. He favours the well-chosen anecdote over the implausible and impractical equation.
The problem with investment is that despite the best efforts of economists suffering from 'physics envy', it is not an exact science. Investment will always be influenced by human behaviour, psychology and irrationality. The challenges today are if anything more acute, in that governments and their institutions (central banks) are fundamentally distorting what might otherwise be relatively free and genuinely open markets for assets and capital.
If you take issue with this, ask yourself where government bond yields would be if interest rates weren't at 300-year lows in order to bail out the banks, or if our banks weren't being bribed to buy them.
There is much to appreciate in this book, but perhaps the most poignant anecdote concerns Martin's attempts to launch a hedge fund after more than 20 years in the business. Having pitched to a (billionaire) acquaintance for half an hour, he gets the following response: "David, there is no doubt in my mind you can do this, but I wouldn't invest a nickel in your fund until you quit your job at Citibank, spend at least $75,000 with a top-tier law firm to put together the necessary documents, and lastly, spend an entire year raising money, without any income. You have the experience and the understanding, but only if you did those last few things would I be convinced that you had the fire in your belly necessary."
For anybody thinking of buying any form of actively managed fund, whether traditional or alternative, Martin provides a very useful checklist, which include the following critical questions:
1. Is there a free flow of information?
How often is the fund's net asset value (NAV) reported? Are the fund managers and its employees accessible? Transparency is vital for an investor. It keeps the fund's management team on its toes and minimises the chances of an investor experiencing any nasty surprises.
2. Does the fund have the ability to stay in the game?
New hedge-fund managers may not raise money as quickly as they might have hoped; their initial investment strategy might jeopardise the existence of the fund by risking even a relatively modest amount of capital.
3. Does the fund have a loyal investor base?
Will those investors remain loyal when the going gets rough? At some stage it always gets rough –
the last thing you want at that point is for the fund to be scuppered by a rush for the doors.
4. Is the fund dependent on a star manager?
Or is there company-wide competence? Stars get headhunted or lose their touch – a quality organisation is more durable.
5. Does the fund have a consistent approach?
And does it have a track record of at least three years? It's pretty tough to get an idea of whether or not a fund can keep outperforming if it's only been running for a few months.
6. Where is the firm in its growth cycle?
You don't want to get to a fund when it's past its best. Does it already command too many assets to be nimble? Once a fund grows beyond a certain level, it's very difficult to act on the best opportunities without influencing the market, or using such a small proportion of your assets that it makes little difference to overall performance. Also, funds can be tempted to gather assets (and so harvest fees), rather than actually managing those assets to ensure they generate good returns for investors.
7. Do the fund's managers have 'skin in the game'?
If they won't invest in their own funds, then why should you?
We are in an extraordinary investment environment replete with new types of risk. Martin's book will help you identify many of those risks. More to the point, it will help you to know yourself, and what you really need from your investments, which is really the heart of the matter.
• Tim Price is director of investment at PFP Wealth Management. He also writes The Price Report newsletter. Visit
www.moneyweek.com/TPR.aspx
, or call 020-7633 3637.
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