Using the IA Flexible Investment sector average to gauge fund performance is more misleading than investors already think it is, warns First State’s Andrew Harman, who says there are many more equity- and fixed income-only funds in the market area than people think.
As such, he says the diversified growth and multi-asset funds will always remain in the middle of the pack for their returns relative to their peers, given that equity and bond market behaviour will innately drive returns of many vehicles in the sector.
Performance of sector vs index since start of data
Source: FE Analytics
The manager, who heads up the First State Diversified Growth fund, says funds that are able to adapt their risk tolerance and have the freedom to invest across asset classes could be overlooked, despite delivering what they have promise.
“The IA Flexible Investment sector is a very wide, all-encompassing universe, so within that you have multi-asset funds – which makes sense, they are flexible in terms of how they invest,” Harman said.
“You also have pure equity or bond funds and the definition of flexible investment just means you don’t have a minimum or maximum to that – you could be zero to 100 per cent equities and you don’t have a maximum on your cash. This means that equity-only funds end up in the flexible investment sector, the same as EMD [emerging market debt] funds that can hold large amounts of cash, for instance.
“I can understand the rationale for funds to have the ability to hold cash if they are in relatively illiquid spaces within equities or bonds. But, the fact that you end up in the flexible investment category generally would mean that, depending on the market environment, your equity or bond funds will either be at the top or the bottom and your mixed assets will potentially end up in the middle.”
First State Diversified Growth aims to return an excess of 4 per cent above UK inflation over a rolling five-year period. To achieve this, it is able to hold any weighting across any asset class - whether they are physical equities and bonds, or derivatives such as futures, options or swaps.
The manager also doesn’t have a risk target so is able to add or reduce portfolio risk when he sees fit. In other words, the fund is entirely flexible.
Yet, perhaps counterintuitively, not every fund within the Investment Association (IA) sector is. According to data from FE Analytics, 28 – or almost one-fifth – of funds within the IA Flexible Investment sector are only able to invest in equities. A further nine are benchmarked against UK either the FTSE 100 or the FTSE All Share and, despite warnings regarding its diverse nature, 33 (or 23 per cent) are benchmarked against the sector average itself.
“I don’t want to prescribe how this could go but I think there could be a reasonable amount of scope in terms of what could be developed,” Harman continued. “Even simply splitting out the multi-asset funds and single-sector funds that have a flexible investment mandate could potentially be a start.
“Or, even within the IA sector there are a number of fund-of-funds, so even splitting out the fund-of-fund investment categories which aren’t exclusively - but tend to - have more static allocation with the underlying sleeves made up of specialist managers.”
In April last year, the trade body launched the IA Volatility Managed sector, which comprises of 83 risk-targeted multi-asset funds with combined assets under management (AUM) of £19.3bn.
Harman says this was a good move from the firm and points out that, within the IA Flexible Investment sector, the diversified growth funds have a combined AUM of £200bn.
“I’m not necessarily prescribing that you need a DGF [diversified growth fund] category, I even think being more specific on what ends up in those categories would help the end adviser,” he reasoned.
“A lot of the time within the sector, the funds that are doing exactly what they say they’ll do – so thinking about my peers you would end up with a lot of ‘LIBOR plus’ or ‘inflation plus’ products that, if they did exactly what they say they would do, would by definition be exactly in the middle of the sector.
“Within the IA Flexible Investment sector, a number of funds in that peer group have chosen to move into the IA Unclassified sector.
“It’s difficult; people have decided they don’t want to be compared within this universe because it isn’t appropriate so they move themselves to unclassified, but then potentially they were the exact flexible investment fund that should have been in the sector in the first place.”
Harman says investors need to understand that many funds in the sector – including First State Diversified Growth – are actually targeting low-beta returns in a bid to offer portfolio diversification.
Performance of fund since launch
Source: FE Analytics
“That’s another measure that is unfortunately further down the line of priority,” the manager said. “The first question tends to be whether you’re achieving your targeted return and, if the answer is ‘yes’, the next question is whether you’re doing it under an appropriate risk framework.
“That might involve looking at the Sharpe ratio so you can actually see what you’re gaining for the additional risk. After that, it’s maybe what the worst drawdown is and what is most likely to trigger this in the future.
“After all of that, it’s really how you have achieved it because, even if you have done all of those things, then depending on the market environment in which you have done it in, this may help the investor work out whether or not it’s repeatable or not.
“There are a number of questions there and I’m not too sure that all those questions are always answered in the choice of the end product. It’s paramount for both for us and for the industry to work out what the best way to educate investors about this is.”
Darius McDermott (pictured), managing director of Chelsea Financial Services, agrees that it is “near-on impossible” to compare many of the funds in the sector. 
“You really do need to know what type of return the manager is targeting for what type of risk. I think it is another difficult IA sector which does not help IFAs or consumers to make fair comparisons,” he said.
“I also think the IA has a difficult job because there isn’t an obvious sector for lot and lots of funds that are doing lots of different things. As an observer, this is another sector which is perhaps suboptimal. It is not easy to make comparisons with some of these funds.
“You could argue that the fund companies decide what sector to go in. There is also the IA Mixed Investment 40%-85% Shares sector which does allow up to 85 per cent in equities, so maybe there are diversified growth funds that shouldn’t be in the IA Flexible Investment sector anyway.
“Some of this is chosen by the fund companies as well so I am not squaring all of the blame at the IA sector. It’s there because of its flexible nature and, if you’re going to be a much lower-risk fund, maybe you should be in one of the lower-risk sectors.”
Martin Bamford, managing director of Informed Choice, says the flexibility of funds within the sector means comparing like-for-like is fraught with difficulties.
“There are funds within the sector which can be compared to their peers, but comparing a single fund against the sector as a whole would not make much sense. That said, investors do have a habit of using relative performance as a selection tool,” he explained.
“Investors can compare fund performance to sector averages across the majority of IA sectors. This approach works particularly well where the sector has relatively strict criteria for inclusion and features a number of very similar funds.
“I can’t see any reason to make changes to the IA Flexible Investment sector, although clear investor warnings about the variety of funds within this sector would be helpful.”