Fund selection proves to be more complex than initially envisaged. Mostly for the following three reasons:
- Past performance is not a good indicator of future performance. Research has shown that funds that performed well over a 5 years span, tended to perform poorly afterwards.
- There are so many different types of funds to choose from.
- People tend to stick to name they have heard of.
The most common fund categories are: actively managed funds, passively managed funds and ETFs. Each comes with its own pros and cons.
Actively managed funds are more expensive with the expectation that they will produce risk-adjusted returns higher than their passive alter-egos’ or benchmarks’ (a market index within which fund managers can pick stocks). If funds fail to do better than their benchmarks, however (in part, often times due to their high fees) then investors will see a delayed return on their principal. Remember, no one can control the market.
On the other hand, actively managed funds may react more promptly during market downfalls. It is also important to understand the kind of index they seek to outperform. The nature of the index they use as a benchmark have a direct repercussion on how fund managers express their convictions. Equally weighted indices constrain fund managers’ stocking-picking less and do not fall prey to bubbles. However, they may exhibit smaller cap biases and induce higher turnovers. Market-cap weighted indices being biased towards the most expensive stocks force managers to own more of those expensive stocks thus limiting their “risk budget” to express stock picking preferences.
The take-away is that investors need to verify how consistently a fund manager is able to deliver the promised risk-return profile throughout market cycles, instead of just looking at past performances. This is what the performance consistency criterion captures.
Passively managed funds tend to be a good way to get a long-term exposure to markets. They replicate the performance of an index they are meant to track.
- Questions to pose when evaluating a passively managed fund are:
- Is the index tracked of good quality?
- Does this index represent part of or the whole market?
- Which biases does this index have?
- Academic research shows that equally weighted indices produce better returns than price weighted ones (link here). Market-cap weighted indices tend to own more the highest price stocks which could cause investors to own more of the overpriced stocks, so less upside potential?
- Furthermore, it is important to evaluate if the index is a good representative of the economy you want to be exposed to.
- You also need to bear in mind that passive funds typically replicate exact market gains as well as market losses with no other risk management overlays.
- On the flip side, keep in mind that they tend to offer real value for money.
ETFs can be categorized as passive replica of indices. As such, these may pose the same challenges as passively managed funds. They also may expose you to risks whose returns are not necessarily passed to investors.
- There are two sorts
- Synthetic ones: it is in fact a structured product that uses complex products such as Total Returns Swaps between a bank and the ETF manager. This means that investors in such ETFs are exposed to a counterparty risk: the bank may fail as seen with Lehman Brothers. How easy will it be to retrieve your money in such an event?
- Cash ones: they own each single constituent of the index they track. In some markets, such approach poses a liquidity risk. The more people invest in it, the “more of the market” it owns. Such instrument may become their own worst enemy as the more the clients sell the ETF, the more the market loses. Furthermore, many cash ETF managers lend the stocks they bought on investors’ behalf to other investors type such as hedge funds, which, again, create a counterparty risk.
- However, unlike passively managed funds, they tend to trade as simply as an equity, a service for which you are charged in addition to other commissions. This is what professionals call a bid-ask spread, which itself is a function of how much demand there is for buying/selling such instrument. This means you buy a portfolio at a premium but usually sell it at a discount.
To circumvent the problem of fund selection as detailed above, Finlight.com enables family officers to curate funds using the following criteria:
- Fund performance consistency.
- Values you believe in (citizenship, socially and environmentally responsible …)
- Liquidity: how easy it is to trade a fund when you require cash back or wish to change your portfolio./li>
- Risk management: how good is a team at managing investment risks.
- Team longevity if you believe that the longer a team has been working together, the better, which is not always necessarily true.
Feel free to peruse our knowledge centre to know more about funds.
The value of investments can go down in value as well as up, so you could get back less than you invest. It is therefore important that you understand the risks and commitments.
This website aims to provide information to help you make your own informed decisions.