We shall be using the terms ‘top’, ‘bottom’, ‘best’ and ‘worst’. These words should not be taken to mean that there is anything intrinsically good or bad about the funds about which we use such terms; they are meant to describe how well or otherwise they fit the criteria we have selected. Where there is an evident reason for the degree of fit, we shall point it up in the text.
Methodology
The methodology used to determine the ‘Top’ and ‘Bottom’ funds will differ for each sector, depending on the predominant aim of the sector. For example, the volatility element would be of much greater significance when looking at the IMA Cautious Managed sector than when looking at equity markets.
The criteria used for the determining the ‘Top’ and ‘Bottom’ funds in the IMA UK Smaller Companies sector are:
· Crown Ratings (Crown Ratings are assigned after measuring three factors: performance, volatility and consistency. The highest rating is three crowns)
· Quartile over both 1 year and 3 years
· Alpha
· R-squared
· Sharpe Ratio
· Information Ratio
· Volatility
· Performance in % and sterling return
Using these criteria it is possible to get preliminary lists of the best and worst funds in the sector. These initial lists, usually containing about 10 funds each, are analysed to reach the final five in each category. We can now turn to the first of our tables and the analytical commentary.
Total return, Bid to bid custom table against benchmark "UK Smaller Companies" from Unit Trusts and OEICs universe
| Top 5 funds | Crowns | Qtl 1y | Qtl 3y | Alpha | r-squared | Sharpe | Info Ratio | Volatility | 3 year Cumulative Performance to Last Price | £1000 invested 3 years ago |
|---|---|---|---|---|---|---|---|---|---|---|
| Invesco Perpetual - UK Smaller Cos Eq | 3 | 2 | 1 | 7.03 | 0.88 | 1.42 | 1.21 | 11.52 | 71.96 | 1719.57 |
| JP Morgan AM - UK Smaller Companies | 2 | 3 | 1 | 3.38 | 0.96 | 1.12 | 1.52 | 14.62 | 71.99 | 1719.87 |
| Old Mutual - UK Select Smaller Cos | 3 | 1 | 1 | 9.90 | 0.93 | 1.63 | 2.82 | 13.80 | 99.90 | 1998.96 |
| Resolution - Smaller Companies | 3 | 1 | 1 | 6.31 | 0.94 | 1.34 | 2.14 | 13.89 | 82.32 | 1823.22 |
| Standard Life - UK Smaller Companies | 3 | 1 | 1 | 7.86 | 0.93 | 1.45 | 2.31 | 14.36 | 92.19 | 1921.95 |
| Sector: IMA UK Smaller Companies | 0 | 1 | 0.83 | 0 | 12.46 | 47.76 | 1477.59 |
Source: Financial Express Analytics. Data to 30/11/2007
Analytical Commentary
Our selection of funds is drawn from one of the better performing IMA sectors in recent years – its average return ranks at 8 out of 30 sectors – but, as we shall see, the overall picture masks some very different outcomes for the individual vehicles. But firstly a note: in previous reports we have based our initial selection of top 5 candidates on the highest Crown and quartile rankings. Almost inevitably in a sector that is pitched at small caps, the degree of performance consistency will not always match the characteristics of mainstream investment destinations. Consequently, in this selection we have placed more emphasis on the other performance indicators in the table, and we can certainly learn something from the funds that appear as a result.
In a sector such as this, our principal concerns will be with the fund managers’ ability to profit from their stock-picks, while not being punished with excessive risk. As a broad measure, Alpha tells us how much return in excess of the sector average the manager has generated, and the clear winner on this count is Old Mutual’s UK Select Smaller Companies. This is reflected in the fund’s headlining return, more than double the sector average, and we shall come to the other factors that go towards making this a winning proposition.
Based on Alpha our other funds also show strongly positive added value, with JP Morgan’s offering only seeming muted because of the company it is in. We should also note that, since its r-squared correlation to the sector is marginally less robust than that of its peers, Invesco Perpetual’s Alpha ought to be treated as an indicative, rather than a definitive, measure.
Two of the top 5 funds have dropped in the quartile rankings over the past year; it is worth remarking that investment in this area of the marketplace should be viewed very much as a long game, and that those funds have held their 1st quartile position over a three-year run.
If we have determined that these managers know how to add value, our next consideration must be the risks associated with the smaller companies marketplace, and how these have been managed. We note here that the sector’s average volatility has been lower over the past three years than that of the smaller companies sectors operating in Europe, Japan and North America.
We have a widely recognised gauge of the risk/reward relationship in the Sharpe ratio. This is calculated after deducting a notional risk-free rate (such as could be earned from a cash deposit) from a fund’s return. In our case we have used 3.5%. The result is then divided by the portfolio volatility, to produce a value for the amount of return generated per unit of risk.
Clearly, the higher the Sharpe the better, and Old Mutual can claim the top slot again. But it is interesting here to see that JP Morgan’s fund carries the highest volatility in the group, and this will have had its effect in producing the lowest of the Sharpe ratios. Volatility is also one of the elements that go into the quant-based Crown rating process, and it is not difficult to posit this as a pivotal reason for the fund’s 2-Crown assessment, despite an impressive level of return. Compare this with a virtually identical return from Invesco Perpetual’s fund: its volatility is the lowest in the group, beating the sector average, and will have fed through both to the 3-Crown rating and the higher Sharpe.
Now let us turn to a more stringent test of managers’ stock-picking skills, and the risk/reward relationship. Like Sharpe, Information Ratio (IR) also deducts a notional risk-free rate from the fund’s return. Then it goes further, and strips out the return that can be accounted for by the benchmark’s movement. The result is an excess return, which is divided by its volatility, to measure the net net return created for each unit of excess risk. As the IR increases, the more impressed we are by the fund manager’s investment skill.
In our sample of top funds, there is no question that every one of them has turned in an unequivocally impressive performance. If an IR of 0.5 invites a murmur of approval, values of 1.0 or more get a round of applause and an encore. So here comes Old Mutual again, with its 2.82 IR almost off the chart. In this performance, the volume knobs on the amps go up to 11, bats get dentally decapitated, and the 70,000-seater erupts into an ecstatic blur of black leather and tattoo ink.
But, at the risk of pushing the metaphor too far, it’s time now to look in on the skiffle combo fluffing chord changes in the village hall. Our next table:
Total return, Bid to bid custom table against benchmark "UK Smaller Companies" from Unit Trusts and OEICs universe
| Bottom 5 funds | Crowns | Qtl 1y | Qtl 3y | Alpha | r-squared | Sharpe | Info Ratio | Volatility | 3 year Cumulative Performance to Last Price | £1000 invested 3 years ago |
|---|---|---|---|---|---|---|---|---|---|---|
| Aberdeen - UK Emerging Cos | 1 | 4 | 4 | -5.87 | 0.91 | 0.30 | -1.35 | 13.51 | 24.61 | 1246.08 |
| AXA - UK Smaller Companies | 1 | 4 | 4 | -5.29 | 0.91 | 0.34 | -1.31 | 13.19 | 25.95 | 1259.55 |
| Capita Financial - Canlife UK Smaller Cos | 1 | 4 | 4 | -16.16 | 0.72 | -0.01 | -1.92 | 15.49 | -11.50 | 885.05 |
| Close - Beacon Investment | 1 | 4 | 4 | -10.24 | 0.73 | 0.00 | -1.43 | 14.29 | 5.43 | 1054.29 |
| HSBC - UK Smaller Companies | 1 | 4 | 4 | -6.68 | 0.91 | 0.21 | -1.68 | 13.11 | 20.16 | 1201.63 |
| Sector: IMA UK Smaller Companies | 0 | 1 | 0.83 | 0 | 12.46 | 47.76 | 1477.59 |
Source: Financial Express Analytics. Data to 30/11/2007
Unlike selecting our top 5 funds, there is no shortage of candidates for this section, and perhaps this underlines the transcendent skill apparent in our top group as much as the egregious lack of it in this one. Maybe it is just possible to say that Aberdeen, AXA and HSBC didn’t do too badly, with 20%+ returns over the three-year period, but this is where we would have to disagree. We must ask, when these funds are well-correlated to the sector as a whole, how it is that their returns have underperformed the average to such a substantial extent? Without adjusting for risk factors, the negative Alphas tell us that if the benchmark had registered no movement at all, these three funds would have shed value all by themselves.
What makes this situation the more unsatisfactory for investors is that, when we do look at risk, there has been no pay-off in terms of a less volatile home for one’s money. This is the least that one could expect from funds that appear to be following consistently a 4th quartile investment strategy. And it this factor that does not make for good reading among our other statistics: on any risk-adjusted measure, they have taken on above-average volatility in return for substantially below-average returns.
Which brings us to the Capita and Close funds. Due to their weaker r-squared correlations to the sector as a whole, we cannot treat the Alpha values as entirely reliable. But this also allows us to infer that the funds have taken positions that are uncharacteristic of the sector’s composition, and we can look at measures that are independent of it.
Looking at total return performance, for most of this group it would be hard to justify the old accusation that these fund managers will take your money and invest it for you until it’s all gone, so we must let the numbers speak for themselves. What is demonstrable is that Capita and Close run atypical portfolios, that they have taken on the highest levels of volatility in this group, and that their investors have been handed net net losses in return.
We would not want to underestimate the degree of skill it takes to wring some action out of the small companies marketplace; and this makes it all the more important to distinguish between those who do so successfully, and those who don’t have amplifiers that go up to 11.