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Don&#39t go wide of the benchmark

Over the last few weeks, I have been conducting a series of seminars on investment portfolio planning for over 1,500 IFAs and around 600 broker consultants. One of the more popular sessions has touched on the interpretation of data in the quality financial newspapers and its uses in mainstream financial planning.

Over the next few articles, I would like to expand the content of these sessions, concentrating on information which can be of prime importance to IFAs.

This week, I will start with an often overlooked section of the Financial Times – the FTSE Actuaries share indices. This quite extensive section appears almost every day in the bottom left-hand corner of the back page of the Companies and Markets supplement. It contains some extremely useful information which can help IFAs interpret and understand the price performance of investment funds.

The recent Myners report and Sandler consultation document stress the need in portfolio planning for appropriate benchmarking of investment and fund performance. A prime example of this need for appropriate benchmarking can be identified as the very different price performance of UK equity funds which hold high-dividend-yielding shares, commonly called UK high-income funds, or low-dividend-yielding funds, commonly called UK growth funds.

If you look at the relative price performance over the last 12 months of these two types of funds, you will find that high-income funds have significantly outperformed low-income funds. It would be wrong to benchmark both these types of fund against a single index – most commonly, the FTSE All Share index or, worse still, the FTSE 100 index.

At the time of writing, the FTSE 100 stands at 5,300 against (looking at the FTSE Actuaries share indices) 6,400 one year ago – a fall of around 17 per cent. The FTSE All Share index stands at 2,560 against 3,060 one year earlier – a similar fall of around 16 per cent. However, these indices cover both highand low-yielding shares (the indices indicate an actual yield of 2.55 per cent).

More appropriate – but lesser known – benchmark indices can be found in the FTSE Actuaries share indices section. The FTSE 350 higher-yield index covers only shares which yield well-above-average dividends – the index has a compound dividend yield of 3.6 per cent, some 1 per cent higher than the more widely-quoted indices mentioned above. At the time of writing, this index stands at 2,990 against 3,170 one year earlier, showing a fall of only 5 per cent in contrast to the 16 or 17 per cent falls in the main indices.

There should be little surprise, then, to find that UK equity funds which invest in higher-yielding shares have significantly outperformed the market when benchmarked against the All Share or FTSE 100 indices. These funds should appear in the top two quartiles of their peer funds (taking their peers as being all UK equity funds).

In contrast, the FTSE 350 lower-yield index (with an average dividend yield of only 1.35 per cent) stands at 2,195 against 3,050 one year earlier – a fall of 28 per cent, significantly worse than the All Share index. It can quite confidently be expected, therefore, that funds which hold these shares will have significantly underperformed the market and will almost invariably appear in the bottom two quartiles of UK equity funds.

In summary, it is vital for an IFA, in assessing and comparing price performance of UK equity funds, to identify the nature of the shareholdings and measure performance against the appropriate benchmark index. To overlook this principle runs the risk (indeed, the certainty) of believing higher-yield fund performance to be better than has been the case and, conversely, believing unfairly that lower-yielding funds have performed badly.

It is not true that higher-yielding funds can be expected always to outperform lower-yielding funds. It is just as likely that lower-yielding funds will significantly outperform the market over the coming year.

Historically, however, it can be identified that, in the vast majority of years, the price performance of these two types of fund has been significantly different, indicating that a holding in both might be used profitably to reduce portfolio risk.

What other messages can be derived from the FTSE Actuaries share indices in respect of an assessment and comparison of UK equity funds? Just as some equity funds specify a preference for higheror lower-yielding shares, others specify a specialisation in either blue-chip shares, medium-sized shares or small-cap shares. Here, again, it is vital for the IFA to identify the appropriate benchmark index.

The index almost invariably quoted in the media is the FTSE 100, covering the biggest 100 shares by capitalisation. As I noted above, this index has fallen by around 17 per cent over the last 12 months. This is clearly the appropriate index for funds which invest in blue-chip shares. For mid-cap companies, a far more appropriate index is the FTSE 250. At the time of writing, this stands at 5,960 against 6,640 one year ago – a much more modest fall of only 10 per cent.

A number of UK equity funds invest only in smaller companies and the most appropriate benchmark index is the FTSE small-cap index, which stands at 2,620 against a level of 3,290 one year ago – a fall of around 20 per cent.

The different price performances of these different ind-ices has not been as marked over the last 12 months as is usually the case but is sufficiently different to indicate the value of using the appropriate benchmark for fund assessment and comparison.

Concluding this look at the FTSE Actuaries share indices, it can be worthwhile for the IFA to look at the indices for the different share sectors. Many UK equity funds invest in shares which are chosen primarily on the basis of what has become known as sector selection. In other words, the fund managers will attempt to identify the sectors which they feel will outperform the market in the next few months and will concentrate their investments in these sectors.

These funds will tend to be more volatile than where the fund managers select shares purely on their individual merit, with no concentration in particular sectors. This is because sector fund management will produce well above-average returns where the selection proves well-judged but could produce potentially disastrous results if the selection proves ill-founded.

IFAs should ensure, therefore, that they are aware of the fund management style of equity funds under consideration.

Next time, we will look in a little more detail at aspects of these FTSE Actuaries share indices. I will also look further at the information contained on the individual share price pages, with particular regard to investors and fund managers seeking to outperform the market according to other mathematical pointers.

Keith Popplewell is managing director of Professional Briefing

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