Fund ‘best buy’ lists

Fund ‘best buy’ lists

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In recent years we have become accustomed to an expansion in the number of choices available to us as consumers and it is no different in investing.  However, increased choice also brings increased complexity.  With personal finance already fairly complex, adding more is not always as good as it seems, as it can cause people to disengage entirely as they despair of ever understanding what they should do.

With the growth of direct to investor platforms expanding the opportunities for everyone to select their own funds, ‘best buy’ lists were introduced by many platforms and advisory firms as a way to simplify the bewildering choice available.  The rationale was that by making the outputs of their research teams available to users of the platform (and sometimes to anyone who wanted to see it), firms could attract investors and their cash and would then earn fees on that capital which would exceed the cost of the research.  As the research was being done anyway, the additional cost of distributing it was marginal.

The research typically tries to identify those instances where:

  1. A fund has outperformed the market
  2. The outperformance was due to skill rather than luck
  3. The outperformance was likely to continue in the future

 

The first is usually an initial screen and is fairly easy in that it is a statistical exercise but care needs to be taken that the ‘market’ used as a comparator is actually a relevant benchmark.  Comparing a UK small companies fund to an index of the 100 largest UK companies will not reveal much that is valid about how well the portfolio is managed as the more appropriate benchmark would be one comprising only UK smaller companies.

The second is an attempt at separating the talented from the fortunate but has been shown by numerous studies to be extremely hard to determine.  Apparently it takes around 20 years’ worth of data to distinguish reliably between skill and luck and after that time anyone who is truly skilled is likely to have retired to their private island in the Caribbean.  One of the better pieces of research, in that it is carried out by a data organisation, covers multiple regions and eliminates survivorship bias, is the annual SPIVA (S&P indices versus active) study.  The June 2020 one shows that over five years (at the lower end of a reasonable timescale for an investor), between 67% and 97% of actively managed funds underperformed their market benchmarks.  As well as the US (97%) and Europe (73%), the markets included several that are often classified as emerging, such as Mexico, Brazil and India (80% each) and Chile (93%).  Identifying in advance who the outperformers will be is clearly a tricky business and the odds are stacked against anyone who tries.

The third requires an assessment of the fund’s processes and how well suited they are to work in the future.  It is potentially the most valuable element as nobody scans best buy lists to see what they should have bought several years earlier- they are interested in the future, not the past.

Most of not all list issuers state that the inclusion of a fund is no guarantee of future outperformance and even if that is for legal reasons, they should appreciate that it is entirely true.  Any number of events can cause processes to alter, such as personnel changes, a takeover or merger or just a decision to change a fund’s mandate.

However, given that the research is carried out by commercial businesses which have an economic interest in the outcome (rather than by academics), it is reasonable to consider the extent to which their judgments may be influenced by that fact.  At a previous firm, I actually used to do this work, albeit for an internal buy list, and I was always happy to tell any of my colleagues who asked about all the flaws in the process that I knew about.  Not that many did ask – those who did tended to know about them already.  In several cases, investments which I would have excluded found their way into the list without passing across my desk due to decisions made at a higher pay grade then mine.

Even if the research process is entirely free of what we might call ‘commercial influences’, it is done by humans (or by machines programmed by them) and humans are subject to inherent biases.  These are based on our own experiences and what we have ‘learned’ (not all of which may have much basis in reality) over our years of working and they influence how we view things.  For example, we may believe in any or all of the following (far from complete) list:

  • Active management works best in inefficient sectors like smaller companies and emerging markets
  • It is worth paying extra costs for outperformance
  • The regulators may say that past performance is no guide to the future but it’s a good starting point
  • Value stocks are a better long term investment than growth stocks
  • A thousand fund managers can’t be wrong

Any of these can lead to a conclusion with which another researcher might disagree.  Looking at more than one list may therefore help, although not if their compilers are not independent of each other.

In any case, particular investment style factors fall in and out of favour from time to time and it is hard to predict when that might be.  Buying a large cap growth fund on the back of several years of strong performance and good process which are sufficient to get it into some best buy lists might not prove that effective if the market spends the next few years favouring small cap value stocks instead.

Even if the process and the people executing it are sound, there is no guarantee that they will not drop the occasional clanger.  Those with memories going back a few years will remember the Ponzi scheme run by Bernie Madoff in New York.  He managed to fool a large number of people, not all of whom were private investors who might be forgiven for not carrying out the sort of due diligence on his operation which might have identified something fishy.  One high profile investment professional ‘victim’ (although it was the end investors who lost the money) described Madoff only a few months before the scandal broke as being “…‘very, very good at calling the US equity market.  This guy has managed to return 1 to 1.2 per cent per month, year after year after year”.  More recently, there is also the case of the Woodford case, which was closed down when a flood of redemptions exceeded its liquidity, despite being highly recommended by at least one prominent advisory firm right up until it was suspended.

More importantly, even buying the ‘best’ funds may not help you much in reality.  The most important aspect of investing to get right is the split between defensive (cash and bonds) and growth (equities and real estate) assets.  By ‘get right’ I mean having the appropriate mix for your own particular circumstances.  This will be determined by several factors, such as your willingness and need to take risk in pursuit of your goals and your ability to withstand the volatility of your portfolio in getting there.  Needless to say, no ‘best buy’ list compiled by someone who doesn’t even know that you exist will help you with that.