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Fee fie

Our panel discuss whether recent hikes in fund charges can be justified and predict where value will come from in the next 12 months.

What is your opinion of the recent spate of fee increases from a number of investment groups?

Ilott: Regulatory costs and squeezed margins have combined to put more pressure on the bottom line for many fund groups. The recent hikes in charges have merely brought the affected groups more in line with the rest of the market. Our analysis of fund costs suggests that where a fund is allowed to invest has far more bearing on returns than charges.

Patel: It is difficult to justify a rise in fees in any circumstances but it is particularly tough when performance is poor. If investors are truly getting active management and superior performance for their fund, then I can understand why certain groups have increased their annual charges. However, the question I would like to ask is whether groups are willing to lower the fee when performance is unacceptably poor?

Connolly: Investment groups are commercial enterprises. They decide what products they will offer and the price they will charge and then consumers can make the decision as to whether they are willing to pay that price. For retail funds, typically 33 per cent of the annual charge pays commission to the financial adviser. Both active fund managers and financial advisers must justify the charges they are taking. If they cannot do so, then consumers should look elsewhere, be that to another actively managed fund, a passive fund or a new financial adviser.

What are the primary advantages of Ucits III legislation for UK advisers?

Ilott: Under the old rules, fund managers can only hope to avoid the stocks they think will fall in value but the potential to use derivatives under Ucits III rules means they will now have the potential to make money from these stocks. This makes it possible for managers to make money in both rising and falling markets, which is going to be a very useful tool for advisers to exploit, especially when allocating money towards specific goals where it is possible to calculate the yearly target return needed to achieve them. We expect more groups to launch multi-asset class and target return-type funds.

Patel: The Ucits directive has always been in place to encourage the cross-border sale of funds throughout Europe, which at face value is not such a bad thing. The main advantage of Ucits III is that it allows greater flexibility for fund managers to use additional assets in their portfolios, such as futures, currencies and the abil-ity to short, in order to generate excess returns. The con- cept is still new and it remains to be seen whether or not this will genuinely add value to portfolios. In addition, we need to bear in mind that fund managers may not have the necessary skills to use it.

Connolly: More flexibility offered by the Ucits III legislation will provide more options for advisers. Some of this may be beneficial but there is a danger that some offerings could be very confusing, with the use of futures, options and contracts for difference, such that advisers do not fully understand the risks being taken, much less the end consumer actually buying the product.

Is there still a place for benchmarks in today’s investment environment?

Ilott: It depends what you want to use as a benchmark. We are certainly wary of using stockmarket indices. The 1980s and 1990s were exceptional. For example, the make-up of the FTSE All-Share index is not the same well diversified home for equity investment that it was 10 years ago. At the end of 1994, the UK’s top 10 biggest companies accounted for just 23 per cent of the index but by the end of 2004 this had grown to 42.7 per cent. Preoccupation with the benchmark and clo-set tracking has meant there has been a mismatch between what ordinary investors thought fund managers were doing with their money and what benchmark-aware managers were capable of doing within their restricted mandates. We prefer fund managers to be given a free rein to shun indices and back their own convictions because this means that their funds are run in a way that most ordinary investors can more easily identify with.

Patel: In reality, private investors have never grasped the concept of benchmarks. When they look at the performance of their investments, they view them on an absolute return basis, not compared with an index or its sector. All they are interested in is positive returns over what they get on deposit and that they do not make losses. However, there is still a place for benchmarks in the context of measuring risk and providing comparisons but only when they are like-for-like comparisons.

Connolly: Benchmarks are necessary for measuring performance but also for understanding how a fund is being run and the risks the manager is taking. Non-benchmarked investments are very much flavour of the month but most clients are invested in equities because they believe this asset class will offer good long-term returns and within the asset class they are looking for consistent performance. Most would not appreciate an all-or-nothing approach where risks are concentrated in one particular area. Benchmarks allow many of those risks to be transparent.

What is your outlook for the commodities sector?

Ilott: Commodities are always going to be a very bumpy ride. Certainly, there has been a short-term pullback on commodity prices but that is what you might expect. The longer-term supply and demand constraints still appear to be in place, especially in the energy sector, which should augur well for the longer term. Returns from commodities also have low correlation with other asset classes, so it makes sense to have at least some specific exposure for diversification purposes in bigger portfolios.

Patel: After suffering from a bear market of nearly 20 years, commodities have only had a couple of years of catching up. There is still significant growth potential left in this sector, in my view. In addition, the supply and demand factors are stronger than before, given the pace at which economies such as China and India are growing and the impact of their demand. Commodity prices are therefore likely to continue rising as demand outstrips supply, so the sector seems set for growth in the coming years. However, it will remain a volatile sector, so be prepared for any shocks along the way.

Connolly: We hold commodities in some of our client portfolios because we believe they offer reasonable prospects over the long term. However, we would not be able to predict how this sector will perform over the shorter term and would certainly not look to increase or decrease exposure because of any prediction.

What areas are you curr- ently wary of being exposed to and why?

Ilott: We are wary on fixed-interest exposure, not because we necessarily think investors will receive negative returns but because we feel there is currently less scope for them to get returns in excess of cash. Yield spreads have narrowed considerably over the past three years and we do not think short-term returns will warrant the extra risks involved. This is certainly a problem area for low-risk income-seekers, esp- ecially given that some fund groups still insist on deducting charges from capital.

Patel: In the current environment, the two main areas to be cautious of are property and high-yield bonds. The potential returns from property are no longer as attractive compared with three or four years ago. There are also too many funds being launched and that in itself is a concern. Second, high-yield bonds have had a good run over the last few years and the risk taken for investing is no longer attractive for the yields on offer. This does not mean that investors should not have any exposure to these areas but they should be wary of the pitfalls.

Connolly: We are wary of being exposed to all areas, which is why we rigorously examine our underlying holdings on a continual basis to ensure that portfolios meet our clients’ requirements and that we can see the underlying benefit and risks in all our holdings individually and also as a collective. We will not take any short-term asset allocation bets. Rather, we establish what is the best long-term asset allocation strategy for our clients and while we may rebalance over the course of time, we will not make wholesale changes because we guess a particular asset class may be over or undervalued at a particular time.

Where do you believe real value is going to come from in the next 12 months?

Ilott: Twelve months is such a short period for anyone to predict accurately what will happen because there are too many variables. However, price/earnings ratio compression between value and growth stocks would suggest that investors should now have a more balanced approach between growth and value-oriented funds. Also, the enormous performance differential between big and medium-sized companies over the past few years cannot continue indefinitely. At some point, performance from bigger companies will revert to trend. The remainder of 2005 is likely to be a testing time for stockmarkets and it is possible that investors will become increasingly averse to taking on higher risks, which could see more money being invested in bigger companies where shares are liquid and can be traded more easily. Historically, bigger companies perform better than medium-sized and smaller companies when growth is slowing and profit margins are being squeezed. This is precisely the environment that many predict for the coming year.

Patel: There are not any major types of investments that look particularly exciting at the moment. It is anyone’s guess. A lot of fund managers are talking about growth outperforming value but we have yet to see this take off in a big way. My philosophy is to stick with the proven stockpickers in any market and over time they should make you money.

Connolly: A sensible long-term asset allocation strategy. Clients value the fact that we will not take any additional short-term risks with their capital because we guess that one asset class may perform better than another one.

What split between equities and fixed interest do you feel investors should be running in their portfolios over the coming 12 months?

Ilott: We do not have a broad-brush top-down view on asset allocation over such a short timeframe. You have to ask what each client is trying to achieve. Most of the time, there will be longer-term objectives or an immediate requirement for income. This means setting out your strategy for the longer term. Even then, the range of possibilities are too numerous to be able to capture in a single general overview. Equity exposure over a 12-month timeline should only be attempted by the most adventurous investor.

Patel: Twelve months is a very short timeframe to give a precise split between equities and fixed interest as this can depend on the age of the client and their timeframe for investing. However, on a personal note, my view is that there is greater potential for growth from equities over the next 12 months. I am also now more cautious on high-yield bonds. Therefore, I would typically increase exposure to equities but balance this by a small exposure to highe-quality bonds and gilts in order to lower volatility.

Connolly: The answer is whatever split is the most appropriate to meet their long-term requirements and match their risk profile. Despite claims to the contrary, nobody really knows how equities or fixed interest will perform over the next 12 months and so positioning client portfolios because of short-term guesses is a dangerous game to play. In the words of JK Galbraith: “We have two classes of forecasters – those who don’t know and those who know they don’t know.”


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