The wonderful world of equity funds
The wonderful world of equity funds
Stock selection is a full-time profession: thousands of companies report numbers and updates on a regular basis. A good portfolio requires selection based on quality, diversification, valuation, risk and the like. Of course, doing that exercise once is not enough: all companies in the portfolio must also be monitored, to weigh the underlying performance of the companies against their ever-changing stock price.
It is ideally the same for non-portfolio companies. Because what was not an interesting entry point yesterday may suddenly be tomorrow. In short: composing and managing an equity portfolio is a fascinating, but also a full-time activity, which also requires the necessary knowledge, experience and discipline. This is why many investors choose not to select a basket of stocks themselves and follow it up daily. They let an expert do this, for example by purchasing an equity fund.
So how do you select the correct funds?
Meanwhile, there are more funds than stocks, so in a sense the problem is shifting. At least as far as initial selection is concerned. Once selected, it is often enough to check only occasionally whether management and performance are in line with expectations. You then no longer need to follow a daily news flow.
The question remains how best to make the initial selection: which fund(s) are buyable?
Much depends on the potential preference of the investor. On his expectations, affinity and risk profile. In what follows, a number of topics are discussed that can be used as guidelines in this regard.
Active versus Passive?
One of the first decisions to make is whether the investor wants to invest in an actively managed fund or a passive index fund, also called an "Exchange Traded Fund" or ETF for short.
In an actively managed fund, the fund manager makes a selection of stocks that, in his or her judgment, should outperform the market as a whole. In addition, it actively anticipates price movements to buy or sell certain positions in an effort to earn additional returns.
With a passive fund, the investor buys "the entire index. The selection is then not done by the manager but outsourced to the index provider's formulas, often MSCI or S&P. In most cases, such indices are "market capitalization weighted." This means that more money is invested in large companies and less in small ones: a company that is 2x as large will have 2x as much invested in it. Regardless of valuation ratios or future earnings expectations of the company. Index investors assume that the market is efficiently priced and save themselves the trouble of forming their own views about a stock. The advantage of a passive fund is that management fees tend to be lower: the selection of stocks purchased is not monitored by anyone and few, if any, transactions happen. So the management fee can be kept to a minimum. On the other hand, as an investor you will never do better than "the market" as a whole. Something an actively managed fund does strive for.
Distribution: regions and sectors
A second choice to make is which regions to invest in. Is the focus on global investing, or do you prefer to buy only European stocks? Do you want to try your luck in burgeoning markets in Asia or, with a touch of chauvinism, may part of the portfolio be allocated to a fund that invests exclusively in Belgian stocks?
The advantage of investing globally is, of course, diversification. By investing very broadly, specific risks are most diversified away. The downside is that a bit more currency risk is taken, and geopolitical tensions can have a somewhat greater impact than with a portfolio that invests only in the Western world. Such risks are compounded when investing in burgeoning markets. Internal politics and regime change can have a robust impact on returns there. On the other hand, some regions have slightly higher growth than Europe or the US. Investments closer to home have the advantage that they are more closely followed in the local press and are generally better known.
The same reasoning can be made in terms of sectors. Does the preference go to a specific sector or to a diversified investment solution?
Complementarity
Important in constructing a fund portfolio is to be mindful of overlaps. It makes little sense to combine a world ETF with an actively managed world fund that tracks this index fairly closely. The top 20 positions will then be very similar and add little diversification to a portfolio. Interesting ratios to keep that context in mind are the so-called "tracking error" and/or "active share." Tracking error measures the volatility of the return difference between a fund and its benchmark index. The higher this number, the more actively the fund is managed and the larger the deviation can be from the reference index. The "asset share" measures the sum of deviations at the level of portfolio weights. It is generally accepted that a number above 60 is acceptable while funds with an "active share" of 90 or higher are clearly sticking their necks out and having a strong opinion.
The extent to which a fund is actively managed, in addition to its return, provides an important indication of whether a manager is worth its higher management costs. High-cost funds whose allocation deviates very little from its benchmark index are therefore to be avoided.
Cost
Be sure to look at and compare fees and first and foremost the management fee. This is the annual percentage charged for managing the fund. However, management fees are not the only fees associated with investment products. In many cases, there is an entry fee and sometimes another performance fee. In this context, it is certainly useful to carefully compare the fee structure. The Belgian regulator, FSMA, has published a good guide on this subject that maps out all aspects of costs. https://www.fsma.be/nl/news/fsma-studie-over-de-kosten-verbonden-aan-beleggingen-fondsen
Who manages the fund?
Obviously, you want to know the reputation of the fund house to whom you are entrusting your pennies. And more to the point: who exactly is the fund manager? We are not talking about the sales manager, but the person who is effectively at the controls and does the day-to-day management. Is that someone with years of experience, or can you expect rather youthful enthusiasm? And how long has the fund been managed by the same person? With funds where someone else takes over management every year, you may wonder whether there is sufficient continuity and whether unnecessary transaction costs will be incurred with each manager change to implement a new vision. Furthermore, it may be interesting to know if that manager is also responsible for other funds. If the same person manages 5 other funds in addition to your fund, you may wonder if sufficient attention is paid to follow up on the shares in your fund.
Finally, communication of the fund house is another area of concern. Is there openness and transparency about what happens in the fund and why, or is communication limited to the minimum required by law? Is there communication even in more difficult times, or does the manager suddenly not give a damn in the event of a stock market crash?
Historical returns
We end by kicking an open door: what were the historical returns of the fund you want to invest in? Often this is the first - and sometimes only - thing potential investors pay attention to. And while past performance is never a guarantee of future performance, past underperformance may, to some extent, be...
Simply sorting all available funds by return and picking out the best is somewhat short-sighted. How much risk was taken to arrive at that return? What is the average valuation of the companies in the portfolio, and how many trades have happened recently? If the fund invested in undervalued stocks in the past, and they have since become expensive and are still in the portfolio, you are buying a fund with a good historical return, but you are getting in at expensive valuations. If profits were taken in the meantime and overvalued stocks were replaced by undervalued stocks, it's a completely different story.
Practical: Fund seekers & Screens
Want to search for a fund that suits you yourself? Then there are online help tools such as fund finders or fund screens, where you can start looking for the suitable fund based on various criteria. Here it is advisable to opt for independent tools, which are separate from banks or financial institutions offering investment services.
Two interesting tools are Time's fund finder and Morningstar's.
At Time you can specify the Time ratings (the Crowns), you can choose by sustainability, choose the manager, sector, region, currency, benefit type, the category and last but not least the risk in the form of the SRI index. The Summary Risk Indicator is a grade ranging from 1 to 7. The higher the number, the higher the risk (as well as the potential return). https://www.tijd.be/markten-live/fondsen/search.html
At Morningstar you can choose from the following filters: fund house, different Morningstar Ratings, Category, management style and ongoing charges. https://www.morningstar.be/be/funds/default.aspx
At Morningstar, you can take a quick look at a lot of parameters for each fund under the heading "Data Quickview." Here you can see the returns for the past 5 years, broken down by year as well as quarterly returns. At least as interesting as the returns, are the risk measures. In the Style Box you can also see how much the fund invests in big caps and small caps and which investment style (Value/Growth) the fund applies in its management.
We wish you good luck! And are also at your disposal for any advice.
