Lucy Walker, fund of funds manager at Sarasin & Partners, believes there are 10 common myths around fund selection that can prevent investors from getting the most out of their portfolio.
In the article below, we take a closer look at the rules Walker thinks investors can ignore when picking funds.
Myth one: Always pick the highest rated funds
While fund ratings are a useful tool in assessing how a fund has already performed, Walker says that investors should definitely not use a ratings upgrade as a reason to buy in.
She stresses that a high rating is not an accurate indicator of continued outperformance. The multi-manager cites research showing that the majority of funds tend to underperform in the three years after they are awarded a top analysts’ rating.
One reason for this could be that a run of strong performance often comes before the manager’s style falls out of favour. Another could be that ratings act as a buy signal for some investors and prompt a wave of money to head into the fund, which makes further outperformance more difficult.
“Having a rating does not guarantee you performance whatsoever and in fact the statistics show you it’s quite the opposite. We would say don’t look at ratings as an indicator of performance,” she said.
Myth two: Back the most experienced managers
It’s only human nature to want the most experienced managers running your money. After all, many of us think practice makes perfect and it makes sense to prefer a manager who has weathered multiple cycles over one who has yet to take a fund through all market conditions.
However, Walker believes that sometimes experience can work against a manager if they become stuck in their ways.
“We do think experience is really important but we also think it should be viewed in context. A study in 2009 found that in your early years, unsurprisingly, experience tends to increase substantially but then tends to plateau out over later years,” she said.
“If we look at performance, it tends to do the same – it tracks experience in the early years, plateaus out and then tends to decrease. This was found to be down to managers getting quite stuck in their ways. Although we do think experience is important, remember it’s not the only important thing and can work to your detriment in certain circumstances.”
Myth three: Flagship funds are safe havens
The multi-manager highlights a noticeable trend in the investment industry: a fund does well early on, attracts a raft of assets and becomes one of the sector’s giants, but then its days of outperformance appear to be over.
“We would say that not all large funds are necessarily going to outperform and part of the reason for that is that bigger funds find it more difficult to invest in the things that perhaps helped them in the early years,” she explained.
“This might be rotation in and out of sector [or] an overweight to small-cap – those kind of things become more difficult the bigger and bigger funds become. We would say that rather than viewing these funds as safe we should consider them as having a bit of detriment towards them.”
Myth four: Never buy a bottom quartile fund
Walker says this is a “really important” myth to dispel, as funds can move from the first quartile to the fourth and back again for good reason. Buying when they’re in the first quartile could mean the investor is on the brink of underperformance, while selling after they have sat at the bottom could mean missing out on future gains.
“What we’re saying here is rather than consider a fund manager as being good or bad because they sit in the first or fourth quartile, instead it might represent the fact that a style is in or out of favour rather than telling you anything about skill,” she said.
“We actually find many of our best opportunities in the fourth quartile.”
Myth five: Use risk-adjusted ratios in isolation
The manager also highlights the tendency of some investors to look at a fund’s current Sharpe or information ratio and base their decisions on that metric. This should be avoided.
“We prefer to look at these ratios on a rolling basis to see how they evolve over time and often this can tell you much, much more than a point estimate of a statistic.”
Myth six: All fund managers are equally active
Walker says this is another “really important” point – just because a fund is billed as being active doesn’t mean it is. She points out that the more a fund overlaps with the benchmark, the greater the likelihood of it delivering beta-like returns and says this highlights the need to find portfolios that look different to the index.
Some members of the funds industry have recently stepped up efforts to demonstrate how active their products really are, with groups such as Neptune, Threadneedle, Majedie and Woodford Investment Management pledging to publish their active share.
Myth seven: Diversification is always good
A fund holding just one stock has 100 per cent risk, Walker notes, as its entire fortune is tied to that individual holding. Adding another stock provides a great deal of diversification benefit and reduces risk, while each additional holding adds a decreasing amount of benefit.
Walker said: “A study found that the diversification benefits are small beyond 15 stocks and beyond 50 they’re virtually zero. We think that it’s important to consider that concentrated portfolios can have a higher chance outperforming.”
Myth eight: Outperforming managers must be skilled
Using the IA UK All Companies sector as an example, Walker points out that the number of funds that have been able to outperform the FTSE All Share is roughly in line with what would be seen a typical Bell curve distribution.
This means that it is open to debate whether that outperformance is down to the skill of the managers or just luck, as you would have expected some managers to make those higher gains regardless.
Myth nine: Rely on past performance
The fund of funds manager says the above point means it’s difficult to use past performance to determine if results are down to skill or pure luck.
“With three years of past performance – which tends to be the industry standard – we only have a 17 per cent probability of knowing if that manager is skilled,” she explained.
“If you want to get to 100 per cent probability, you would need a 160 years of past performance – which is ridiculous. Performance is absolutely a useful tool but it shouldn’t be used in isolation.”
Myth ten: Stock pickers should outperform in all markets
There are times when there is little dispersion in the markets and most stocks deliver similar returns. At other times, some stocks make large gains while others fall.
Walker said: “We would say that scenario two gives much more opportunity to outperform – or indeed underperform – as increased dispersion in stocks allows the manager the change to have selected [winning stocks].”
She adds that it could be better to go passive when there is little dispersion in the market.
In coming articles, FE Trustnet will take a closer look at these myths to show exactly how they could affect an investor’s portfolio.