It is so comprehensive these days that its seems unlikely there isn’t a stone left unturned in the quest for the Holy Grail of investment success, that illusive process that always means you win, you always beat the market. Unfortunately, or perhaps fortunately, it doesn’t exist and can’t exist. So when selecting an investment, I believe you need to be pragmatic and circumspect.
Investment horizon
The first thing to consider is the time period you are investing for. In a nutshell, the longer, the better.
Time gives an investment the opportunity to perform, to come through difficult periods in the market and economy and actually grow in value. It should not be forgotten that the return on equity investment occurs because a company grows its profits; if they don’t, their share price falls.
I always think investors should consider their time horizons as if they were a business: you wouldn’t buy a shop and expect to sell it on in six months for a profit, your plans would be much longer term than this. Three years is really the minimum investment period and anything shorter, especially less than 12 months, is gambling on price movements.
Risk tolerance
The next consideration is risk. Most investors will have a good idea of their appetite for risk, if not there are lots of risk-profiling tools available to help.
From an investment-selection perspective, risk should also be seen in the context of the construction of a portfolio. It is of course possible to select a number of lower-risk investments, but if they are all invested in the same thing, then perhaps risk isn’t as low as hoped for.
Strategy
Finally there’s the strategy. Typically this is either income, growth or a combination of the two. Most investors will probably know what they want to achieve in the long-term. It is worthwhile though re-iterating that dividends when reinvested contribute a major part of the return on investments and this should not be under-estimated.
So once you know – how long for, how much risk and the strategy – the actual investment selection can start.
Given that the future is not predictable, it is always best to have a balanced and diversified portfolio. So when looking for new investments, ensure they fit within the portfolio and that there is not too much exposure to any particular region or sector.
A critical part of selecting a fund for me is ensuring that I understand it. If I do then there shouldn’t be any surprises whether the market is rising or falling, because the fund is behaving as expected.
If it isn’t, then I have misunderstood it. Another important benefit of understanding a fund is that I am more able to fit it into a portfolio.
When looking at funds, there are some key points to cover: what is the market cap range it is investing in and how flexible is this? Lots of funds are multi-cap, but some can range from being all large cap to then being all small cap; others have tighter guidelines.
The wider the range, then the greater the potential risk and of course return. But it also makes it harder to know where that fund is invested at anyone time.
How concentrated is the fund? The smaller the number of stocks the higher the specific risk within the fund. This can help performance but it also raises risk.
Academic studies indicate that if a fund holds 25 stocks, then full diversification has been achieved; reality doesn’t bear this out in my experience. So the fact that a concentrated fund has not experienced high levels of volatility does not mean that it can’t and won’t in the future.
All funds have an investment process, the method through which the manager arrives at the stocks held within the fund. There are many variations of these, some complex, some simple, some driven by the macro outlook; some just based on the potential of each stock, some a combination.
Understanding this is important because a fund that is purely driven by stock selection may not fare so well in a market driven by macro events and political decisions.
Then there are the quants to consider. These have become very popular in recent years as a means to compare funds. However, they are not always easy to decipher and don’t paint the whole picture; what’s more, they are backward-looking, when investment selection is about the future. They do, however, offer a limited degree of insight into fund behaviour.
At the heart of all funds there is a human being, the manager. Their record with the fund is extremely important and the longer that record, the better.
I am not a great fan of transferring performance records when managers move from one investment group to another. A transfer can work or can fail.
From an assessment point of view, the more time spent managing a fund, the better, as this is one of the best insights into the ability of the manager and their team.
At the end of the day, the culmination of everything that goes into the investment process, thought processes, fund construction and so on comes out in the performance. So a manager with a long record through different market conditions is more easily assessed.
The assessment of a fund takes into account all of the above and it is an assessment of these parts and how they fit together that leads to the final yes or no decision. It isn’t a black and white science, far from it, because the human element within fund management is huge. In the short-term, psychology can have a major impact on markets and managers, which brings me back to the need for a long-term perspective, because economic fundamentals are far more dominant in the long-term.
Sometimes in this process, certain factors will be more important than others. If I am looking for a higher-risk growth fund, then more stock concentration, flexibility and higher activity levels would be suitable.
On the other hand, if I want consistency and predictability, I would want less concentration, a less dynamic process and an underlying bias towards quality within the investment process.
In summary it is best, I feel, to take into account as many factors as you can. That an emphasis should be placed on some of those factors depending on what you are looking for, but most of all a clear understanding of the fund is gained. That way there shouldn’t be any nasty surprises in the portfolio.
Tim Cockerill is head of collectives research at Rowan Dartington. The views expressed here are his own.
