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FOF for the future

The last three years have been the most difficult that I can remember since I started in the City of London as a trainee fund manager in the early 1960s. This may seem surprising, particularly to those of you who, like me, lived through the bear market of the mid-1970s.

Why has this been more difficult? Well, mainly because so many more investors have been affected. In the 70s, most private client investors were experienced to a certain degree or had their portfolios managed by professional investment managers.

This time, many new investors have been affected and they had made their own decisions based on a little knowledge and got used to significant annual returns on their capital. Now they have had three years of pain, they are in fear mode.

One of the reasons for the fall in the market was the bubble created by investors anxious to find the double-digit returns they had seen through the period of high inflation. They failed to recognise that in lower inflationary periods market returns will be less.

For example, in the 1960s when inflation was at or around current levels, fund managers looked for returns between 7-10 per cent and clients were happy to accept this.

Another reason has been the degree of style change which has created a greater degree of performance volatility then I have ever seen.

There are now only a handful of funds and managers that have been consistently in the top half of their sectors over the last five years. Add to this the economic factors of a global slowdown and you have a bear market.

The investment marketplace has become more complex with high-profile fund manager defections, extremely volatile investment performance and changes in regulation. I believe funds of funds can be the solution to all these problems and can give comfort to clients and IFAs that they will achieve good quality long-term returns.

Investors have suffered over the last few years not only from a prolonged bear market but also from a volatility of investment performance not previously experienced.

Investment company mergers and fund manager defections to set up investment boutiques have hit confidence. Gone are the days when investors could select one fund management group to look after their money with a feeling of certainty that they would achieve good quality long-term returns and consistency.

Fofs compete with discretionary and advisory unit trust services and discretionary management services such as those provided by stockbrokers and other fund managers. Fofs are the most efficient from a regulation and compliance point of view. In fact, I will say they are the cheapest of the options.

This may seem to be a strange comment when one of the main criticisms that Fofs have suffered has been the “double-charge” effect of a unit trust investing in other unit trusts. In the early days of Fofs, this was a major problem. But things have changed dramatically over the last few years and these changes have been beneficial to Fof managers and to the double charge they suffer.

First, the introduction of renewal commission typically reduced the underlying fee from 1.5 per cent to 1 per cent. Then the introduction of the Oeic and the opening of institutional shares, which quite often charge fees of 0.5-0.75 per cent, has further reduced the burden. However, the most important aspect of this double charge is that it is seen for what it is. It is effectively the investment management fee that the Fof manager is charging and should be compared with similar fees charged by discretionary and advisory portfolio managers. In this context, it is neither high nor onerous.

Indeed, Sifa, the Solicitor IFA organisation, recently stated that the capital gains tax efficiency of a Fof added around 1 per cent a year to capital values. With the underlying fees now reduced to nearer 0.75 per cent as an average, you could almost argue that you are getting your Fof management free.

As you may know, as an authorised unit trust, a Fof does not pay capital gains tax on any internal transactions. This effectively means a client using a Fof for their portfolio management service is deferring any CGT liability until they sell the investment. Most investors continue with their portfolio management arrangements until they die, when any liability dies with them.

There are a number of challenges that investors face when building a managed portfolio. You need to review portfolios constantly and have a thorough research process that identifies the effect of fund manager changes, provides you with a sufficiently high level of diversification of management styles and is actively managed to avoid high-profile disappointments.

Diversification of risk is increasing in importance. It has always been recognised that there is a need for geographical diversification within a client&#39s portfolio and over the last nine years no region of the world has been the best-performing area in any two consecutive years. Japan, which has been a significant disappointment over this period, was the best-performing market on two occasions – 1994 and 1999.

However, the performance differential between the major world markets has been declining over the last few years as we have moved into global market conditions.

The real effect of global markets is seen in sector divergence. As growth or value styles dominate across the major markets, the performance differential between the sectors has been very marked.

For example, in calendar years 1998, 1999, and 2000, the difference between the best and the worst-performing sectors was close to 100 per cent.

The effect has been to destroy any kind of performance consistency. For example, in the five-year period up to the end of 2001, only one North American unit trust out of a total of 70 in the sector, five UK all companies funds out of a total of 205 and five European funds out of 79 were consistently first or second-quartile and no unit trust in any of these sectors was consistently in the first quartile.

Not surprising when you consider the style rotation that we have seen over the last four years. In 1998 and 1999, the growth style dominated across all world markets whereas in 2000 and 2001 the dominant style was value. This meant that funds and fund managers that performed extremely well during the technology boom at the end of the 90s underperformed significantly in the first two years of the new millennium.

The Fofs has had the advantage of allowing us to construct portfolios that diversify risk without compromising return potential.

So how do we as funds of funds managers achieve this? Firstly we look at our process on a top-down basis. By getting macroeconomic information from the major investment houses in the market we are able to shape our asset allocation view and ensure that from a style point of view we have exposure to the area of the market most likely to perform over the next period.

From an asset allocation point of view, we believe it is important not to take exces-sive risk. In the early 90s,when the Asian markets were performing particularly well, many investors had as much as 25 per cent exposure to this area. Asia represented less than 3 per cent of world stockmarkets and clearly this is excessive risk. We take this into account when shaping our asset allocation views and will only be marginally overweight in any of the world markets at any point in time.

By far and away the most important investment strategy decisions we take are connected with investment style.

By having a balanced Fof portfolio with exposure both to growth and value styles, we will reduce the volatility and ensure that when styles change we have an approach that will weather the storm.

We do take positions that will overweight the growth or value style but part of our constant review process is to ensure we have not taken an extreme view. For example, in February 2000, following the enormous boom in the technology sector, we were overweight in growth investing. We made a decision to reduce our exposure to growth to rebalance our overall strategy.

This meant selling technology funds and reinvesting the proceeds in income funds, which are typically run on a value basis. The timing of this move was near perfect but the reasoning behind it had more to do with our overall investment strategy than necessarily our ability to predict what will happen.

The next area we look at in our Fof strategy is bottom-up. The FSA tells us past performance is no help or guide to us in shaping the funds we should buy. We do not entirely agree with this. While it is suggested that managers&#39 periods of outperformance are entirely random in nature, we advocate that by examining manager/ fund characteristics, we can determine likely performance outcome.

We believe it is important to establish the records of funds and fund managers against their peer group. We look at three years, one-year and six-month performance numbers to establish a core universe for each sector from which we do our more detailed analysis and set up our buy and sell lists.

We think it is important to be aware of emerging trends in the market. We look at shorter-term records over six months and three months to establish a potential candidate list for the core universe, which again we analyse.

Once we have established our core list we set up face-to-face meetings or one-to-one conference calls to identify how a fund&#39s performance has been achieved, what the key drivers may have been to excess return, whether the fund performs well in a variety of market conditions and the implications of the investment process. We also insist on twice-yearly updates with fund managers as a minimum requirement for any holdings we may have.

Fofs are the rising star of the investment management firmament. IFAs need to look at this area and to use Fofs as a core holding for clients&#39 portfolios. If 60-70 per cent of a client&#39s money is invested in a Fof, this still leaves scope for the intermediary to overweight the client&#39s portfolio in areas that more accurately reflect a client&#39s profile and requirements.

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