Potter (pictured) says that investors often overlook troubling changes to their fund when times are good and are caught out later on.
Being alert to these factors and adapting your approach is essential, he warns. “If you don't embrace change and back it with conviction you will get average performance. If you do things a bit differently, you can achieve outperformance,” he said.
Here are the four chief red flags he says investors should watch out for.
Changes in behaviour
Potter says investors need to analyse when their funds are likely to perform and make sure they have a mixture of styles.
“It is no surprise to me that there are very few managers who can outperform in bull and bear market conditions to create overall outstanding performance,” he said.
“As there are very few of them around, you'd better some work on when they do and when they don't perform.”
Potter recently told FE Trustnet the funds he tips to perform well both in cases when markets are rising and when they are falling.
“It is also very important to understand the fund manager’s investment style and recognise whether they are principally value or growth oriented, and how they move between to the two styles,” he added.
He says analysing the liquidity is also very important in ensuring you know how long it takes a manager to liquidate their portfolio.
“If you pick funds yourself you have to do this work to justify your existence.”
Rob Gleeson, head of research at FE, says that it is a red flag if a fund starts behaving differently from how you would expect it to.
"If a manager doesn’t perform in the market environment that you bought them for may signal a change in outlook and strategy, in which case investors need to be aware," he said.
"You can't just look at the performance after the markets have turned, so you need to understand the strategy and whether it is changing."
Changes in fund management
Potter says fund managers – even the most well-known names – will move on from their current jobs, potentially drastically altering a fund’s investment style.
This is something investors need to take into account, but it’s not just changes in the manager that matter.
“Just look at some of the well-known names that have moved on in the last 12 months: Richard Buxton, Dickie Hodges and Neil Woodford. Change in management is inevitable,” he said.
“It doesn't surprise us at all that some of these big names have moved on from some of their rather large funds.”
“We like funds that are controlling capacity because it allows the manager to carry on delivering performance.”
“When we look at change at fund level, the change of the fund's manager is only one ingredient out of many factors that alter a good fund. It is a pretty important one but nevertheless there are four areas we need to understand,” he added.
“We try to understand the qualitative factors that are driving the business, team, process and fund.”
“Imagine the chief information officer of a fund resigns and the young fund manager who has been given the break to run the fund and has been given the job by his CIO, how do you think they are going to feel now his mate is gone?”
“Then the number two resigns because they feel they are not going to get the number one job. Meanwhile the fund has been hoovering up money and making a loss."
Changes in the underlying companies
Potter says investors should also take care to look under the bonnet of a fund to see which of its core company holdings are going through senior management change and what effect this could have on the business.
“Companies are changing all the time from good to bad and bad to good,” he said.
“They change particularly with the exit or entry of a key executive position such as the chief executive officer or the chief information officer. Believe it or not, people in businesses create culture, good or bad.”
“Investors need to make sure their fund managers understand the culture of a business and what is changing within that business.”
A case in point is Royal Bank of Scotland. Its share price has been affected by multiple forces since its near-collapse in 2008, including the departure of its chief executive officer Stephen Hester in June 2013.
Hester had taken over from Fred Goodwin in the depths of the financial crisis and the news of his departure had a substantial effect on the banks share price.
It lost more than 17 per cent of its value in three weeks until there was clarity over who was his successor.
Performance of stock and index since over 3yrs
Source: FE Analytics
However, it has since risen from this drop, gaining 25.49 per cent.
Changes in the market
Potter says indices can change, although a lot less quickly than funds or companies, making even passive funds look very different over time.
He gives the example of the Chinese economy becoming more consumer-focused in recent years.
This made the composition of an index of the largest Chinese companies such as the MSCI China become very different over several years.
As a result, different sectors changed at different speeds and by buying the £136m JPM Consumer Trends fund, run by Peter Kirkman he was able to take advantage of this, more than he would have been able to with a tracker.
“Three years ago everybody was telling you to buy emerging markets as western economies were going to hell in a basket and that was the only place you would get growth," he said.
“However, the IMA Global sector over this period has completely walloped the IMA Global Emerging Markets sector yet the expert allocators told us to buy emerging markets. Meanwhile Peter Kirkman has done a rather good job.”
“So those clever asset allocators loaded up on emerging markets and came to entirely the wrong conclusion.”
The IMA Global sector has returned an average of 22.63 per cent compared to an average loss of 4.24 per cent in the IMA Global Emerging Markets sector, according to data from FE Analytics.
Performance of fund and sectors over 3yrs
Source: FE Analytics
The JPM Consumer Trends fund, which is in the IMA Global sector, made more than five percentage points less than the average return in the sector over this period, with a return of 17.12 per cent.