The Secrets to Choosing the Best Investment Funds
Most people have some form of investments. Whether it’s in a stocks and shares ISA, in a pension or a general investment account, we all hope our investments will provide us with a decent return and increase our wealth so we can afford the things we need in the future.
In general, those investing for the short-term (less than 5 years) should probably look at lower risk assets like a high interest savings account, but for those willing to take a little risk and invest for the longer-term, there could be some really strong returns to be had.
Many people find the idea of investing a little daunting as there is so much choice and so many technical terms. In the UK today, there are tens of thousands of investment funds, all with their own distinct characteristics. How do you narrow down that choice and what is the secret to choosing the best investment funds?
Is there a secret to choosing the best investment funds?
Well, yes and no. If anyone tells you there is one sure-fire way to pick the best investment fund or that any particular fund is bound to provide a great return, this should be viewed with a great deal of scepticism.
The reality is that you can’t be sure of picking a great investment fund, but you can ensure the odds are in your favour.
In the same way that nobody can be sure of living to 100 years of age, we never know what the future will bring. There may be those that smoke 40-a-day, eat a bad diet and rarely exercise that get their telegram from the Queen, but there will be many more reaching this age who live a healthy lifestyle and do things right. The same is true for investing; do the right things and invest a little time and you stack the deck in your favour. You won’t get all your decisions right, but over time, you should pick more winners than losers and see your investments grown in value.
So let’s take a look at some of the key things to consider when choosing an investment fund:
There are many different types of funds. The first major difference is what they invest in; equities (company shares), bonds (loans to businesses or government), property (usually commercial property rented to companies), cash, commodities (oil, gold, timber, etc.) alternative investments (anything else) or a blend of all or some of these types of assets. It is important to understand what the fund you are looking to invest in aims to do and the assets it holds and asks whether you are comfortable investing in these things and understand where your money is going.
Geography & sector
Many funds have a particular remit such as investing in the UK, Europe or Japan. Others invest globally, but stick to a particular sector or niche like ‘smaller companies’, banks or pharmaceutical companies. At all times, investments in some parts of the world or some market sectors will do better than others. Some investors try to pick the areas they think will do best in order to boost their returns. Our experience and many academic studies have shown this is incredibly difficult to get right and it is probably best avoided. Simply pick a good spread of investments that are not too concentrated in one particular area. The risk with attempting to pick the ‘winning’ areas is that you get it wrong and your investments really underperform.
Many investors look religiously at the past performance of investment funds but academic studies have shown it is often not a great indicator of future returns. It is important to try to work out whether the returns produced have been down to the skill of the fund manager or just some short-term luck. It’s also worth looking at the amount of risk the fund took to get the return. It may be the top performing fund but if it is twice as risky as similar funds, is it still a good place to put your money?
All investments carry risk. Typically, investors look at the ‘volatility’ of a fund – whether the return is a nice smooth line or jumps around all over the place. When investing it is important to think about whether you will be able to handle any falls without being uncomfortable and whether the bumpy ride is worth it for long-term growth.
Charges are one of the few things that are broadly predicable in the world of investing. All things being equal, funds with lower charges will provide a higher return – because there is less drag on performance. Take care to look at the ‘TER’ or ‘OCF’ (rather than the ‘AMC’) as this will give you a better idea of the actual charges. The fund management industry is slowly becoming more transparent on fees which is something we very much welcome. Whatever the charges of the fund, you must work out whether the charge is likely to be justifiable and could still give you a decent return after it has been deducted.
Increasingly, investors rely on fund ratings to help choose funds. There are many different fund ratings but each essentially tries to highlight the best funds by using certain ranking criteria. These fall broadly into two types. ‘Quantitative’ ratings rank funds based on their past performance. This is usually a measure of the return and risk the fund has demonstrated with the highest returning, lowest risk funds given the best scores. ‘Qualitative’ ratings are an expert judgement on the fund, typically based on interviews with the fund manager and an assessment of their investment philosophy and processes. Fund ratings can be useful but it is important not to place too much reliance on them – they still can’t predict the future with much certainty.
Active or passive
Investment funds can be broadly split into two types; ‘active’ and ‘passive’. Active funds employ a fund manager to make active calls on which stocks to invest in and when to buy and sell. Passive funds typically track a particular investment market and provide ‘average’ returns. Before deciding whether to invest in an active or passive fund, you need to think about whether the additional costs of active investment are likely to provide you with additional returns. Our view is that active investment tends to work better in some markets than others so care should be taken when making this choice.
Portfolio concentration and turnover
When considering which investment funds to put your money in, you may want to think about the make-up of the fund. Some funds are really concentrated – investing in a small number of funds. This is higher risk, but can give strong returns when the manager’s convictions are proved right. Other funds are more broadly spread to minimise risk. In addition, some funds have a very high turnover of assets – in other words, the manager buys and sells a lot. This can increase costs and the manager must be confident their trading will increase the value of your investments. Other funds employ a ‘buy-and-hold’ strategy with very little activity; typically to invest for the long-term. You should think which style you are most comfortable with and how each fits with your own objectives.
The word of investing is full of technical statistics, ratios and analysis. Modern technology means that much of this information is available to all investors. Whether it is ‘alpha’, ‘beta’, ‘Sharpe ratio’, ‘active share’ or any of the myriad of metrics, there is no shortage of stats and analysis available. The problem is one of understanding and interpretation. To most people, these statistics are almost meaningless and care should be taken if using any of these statistics to help choose an investment fund unless you understand the intricacies of the measurement used and what it is really likely to mean.
Investment funds range in size from a few million pounds to tens of billions. There is no ‘best’ size for an investment fund but it is something worth considering before you invest. Smaller funds can be more nimble, buying investments quickly and efficiently but may not have the scale or resources to research the market as much as the larger funds. The bigger investment funds have clearly been popular with investors (hence their size) but when funds get too big they can become unwieldy and hard for the manager to deliver strong returns. Some funds even close to new investors when they become too big to protect their investors.
The past performance of funds is used as a major selling point by investment companies. Before investing, it is worth considering how long the current manager has been in place and whether the performance shown was down to them or a predecessor. Average fund manager tenure in the UK is now around 4.5 years and falling so it is an important consideration when looking to invest. Some websites like Citywire provide ratings for fund managers (rather than the funds themselves) which can help when managers move between funds.
Most investors look for a number of funds to invest in, rather than just choosing one. This can be a sensible approach so you don’t put all your eggs in one basket. It is important to consider how the funds you select will work together. Think of your funds like a team – you want different funds doing different jobs. Ideally your investment funds would be diverse and exhibit different characteristics so they didn’t all rise and fall at the same time for example or all rely on the same type of asset performing well. However you structure your investment portfolio, you should consider the blend you create and what this might mean for your returns and risk.
Choosing the best investment funds can be a tricky and time-consuming job. But it doesn’t stop there. The one thing that is pretty certain is that the best funds today probably won’t be the best funds a year or two down the line. It is probably even more important to keep your investments under review than it is to pick the best investments at outset.
Whether you feel confident choosing, monitoring and reviewing your own funds or you choose to delegate this to a financial planner, it is important your investments are right for you and deliver the very best returns so that you can achieve your goals.