How to pick a good fund

Anyone with access to the internet or the latest copy of Investment Week can probably tell you the best performing funds of last year. But, unless you happen to have a TARDIS or a DeLorean, that information isn’t going to be overly helpful. Rather, it’s more likely to stoke the fires of hindsight and leave you dreaming of what could have been…

But identifying future winners….that’s much more valuable.

So in the same way you do due diligence on Parmenion as a platform and Discretionary Fund Manager (DFM), we in turn spend a great deal of our time researching and analysing the vast universe of potential funds on offer.

Form is temporary, class is permanent

Top of the pile performance isn’t everything. At Parmenion Investment Management (PIM), risk comes first; it’s central to everything we do and fund manager selection is no different. First quartile returns are great, but if they’re followed by a period in the fourth quartile then all of a sudden things start to feel a lot less appealing.

Rather, we seek to invest in funds with attractive risk-adjusted returns. By that I mean finding fund managers that can outperform the market but do so without taking excessive risk. This gives us more confidence is their ability to maintain good performance going forward.

Navigating the Risks

Risk can take many forms and be measured in any number of ways. Volatility is a key measure for us and many other investors, too. It plays a big role in a client’s investment journey. We want our active managers to demonstrate a lower volatility profile than the market – which they historically have – because this ultimately plays a key role in the overall risk control of our active solutions. Importantly, however, it is the lower volatility in negative markets (downside protection) that we care about the most.

A ratio like the Calmar helps with this. It looks at average returns relative to a fund’s maximum drawdown, essentially removing positive/upside volatility (which we all like!) from the analysis. Miton UK Multi Cap Income is a fund that has historically had very good risk metrics. A focus on companies with low debt levels and the ability to pay and grow their dividend has provided a strong defensive base that, in combination with the upside premium seen in smaller companies, has provided excellent results.

Many of the factors that might bring a funds’ future performance into question, however, require a more qualitative assessment. Liquidity is one such factor and an important one for us as we use direct property within our multi-asset framework. We spend a lot of time talking to our property managers in order to understand aspects such as the current level of asset flows, cash levels, pricing methodology and market transaction data, for example. All of this helps us piece together a clearer picture of the current landscape.

The access afforded to PIM as a DFM for this type of work is a key benefit to outsourcing investment decisions, in my opinion. I recently met with L&G UK Property, a fund we’ve held for a long time. They’re holding a 25% cash balance at present, have a vacancy rate comfortably below the market average and are underweight in cyclical sectors such as retail. These are the kind of defensive characteristics we seek.

Not for us, thanks…

There’s been a lot in the press about Neil Woodford recently, centred on both the performance and the potentially illiquid nature of his UK Equity Income fund. A lot of the factors involved here actually resonate quite closely with risk related reasons we wouldn’t hold a fund. We require a manager to have a long track record, but with a single fund management firm e.g. his Invesco track record is not his Woodford IM track record. If we invest in a UK Equity Income fund it’s because we want exposure to that asset class, not exposure to private equity. The equally important point here is that we need to be comfortable that a fund can handle redemption without the dynamics of the fund being altered. Less liquid holdings combined with large underlying holders bring this into question.

Overall, we want managers with the type of mentality that puts risk in the centre of their process; out performance shouldn’t be their sole measurement of success. And all of this, actually, is not necessarily a criticism of Neil Woodford as a fund manager – his fund is just not one that we feel now fits into a risk orientated investment solution.

Consistency is key

The fact the majority of this article is actually about identifying risks rather than out performance is probably a fair reflection of how we look at things – and how our selected fund managers do too. The overall outcome of this is lower risk grade volatility for our active portfolios, compared to passive, as well as out performance over the long term. The ability to protect capital in negative markets can have a lasting and meaningful impact on returns. For this reason, while you can expect the PIM fund selection process to certainly evolve and be enhanced over time, it will always stay true to a focus on risk control and downside protection.

Read more articles on fund selection:

Identifying a great fund, to create the right blend

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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