There’s a lot of merit in doing your homework and making sure that the manager you’re invested in has a proven track record at delivering the goods across a number of different market conditions.
As I argued in an FE Trustnet article earlier this year, I’m not of the opinion that active fund management is purely a game of chance – there are some who are very good at it, and some who aren’t, and like anything in life, experience counts for a lot.
What is more dangerous, however, is to invest in a fund that has had a good run because the asset class it has focused on has shot the lights out.
Without putting performance into the context of what the markets have done, you could find yourself in a consistently underperforming manager who happened to be in the right place at the right time.
Even the very best managers cannot perform miracles, as those who focus on gold equities will tell you based on their recent run. Just because an asset class has done well over one, three, five or even 10 years, this doesn’t mean it will over the next.
If you’re a believer in "the reversion to the mean" argument in the context of market cycles, if anything, strong performance should be taken as a reason to be wary – not bullish.
Looking through the list of underperforming funds that many of our readers have written in to tell us about, three types of portfolio were prevalent throughout: those that focus on emerging markets, those that focus on natural resources, and those that focus on bonds. And what do all of these sectors have in common? They had a stellar run in the early and mid-2000s.
Now of course these funds, which include the likes of JPM Natural Resources, Kames High Yield Bond and Aberdeen Emerging Markets, may have been held within the investor's portfolio for well over a decade, but all of them have seen a wave of inflows in the last five years or so on the back of strong past performance.
JPM Natural Resources saw assets grow by more than £1bn in the second half of 2010. Since then it has been a terrible time for commodities and the fund itself, meaning that many of the people who bought it on the back of past performance have been left disappointed. Perhaps disappointed is an understatement, as the graph below suggests.
Performance of fund and indices since Jan 2000
Source: FE Analytics
"A lot of people look at funds that have done well and think 'yeah, I want a piece of that'," said Tim Cockerill, head of research at Rowan Dartington. "The problem is, that’s often the worst time to buy."
Anyway, that’s enough about past mistakes – let’s look at how investors can protect against potential stumbling blocks in the future.
Cockerill points to large cap, defensive equities that pay a dividend as a potential trap given their stellar run since the financial crisis.
"Looking at what’s done well recently and what investors should be wary of, I think a lot of quality businesses could come under pressure – those with a dominant market position, strong earnings growth, strong balance sheets and so-on."
"You hear so many managers talking about quality, low debt and dependable earnings. I think it comes to a point when investors will recognise that the companies are trading at very high multiples and will look to something cheaper instead. If this were to happen, you could see a very big sell-off."
Performance of indices over 3yrs
Source: FE Analytics
The companies that Cockerill is describing tend to have a yield and focus on dividends. Our data shows that the FTSE 350 Higher Yield index has significantly outperformed the wider FTSE 350, and not surprisingly also the FTSE 350 Lower Yield index.
He continued: "Over the long-term, I think quality will win-out, but I wouldn’t be surprised to see a broad sell-off in these kinds of stocks."
"If you look at something like Unilever, it’s had an unbelievable run since 2009. Just recently there’s been a bit more volatility in the share price, which could be a sign of things to come. This isn’t to say it is a bad company – it’s just had a very good run."
Performance of stocks and index over 5yrs
Source: FE Analytics
His worries echo those of Ruffer’s Steve Russell, who told FE Trustnet earlier this year that he fears a bubble is forming in the equity income market.
Cockerill also points to infrastructure as a possible problem area. The asset class has had an excellent run in recent years, proving popular with investors who want a high and rising level of income. All six of the infrastructure trusts in the AIC universe are currently trading on double-digit premiums, with attractive headline yields to boot.
"The predictability of income from infrastructure is undoubtedly a very attractive thing, but there’s a risk in getting into it now, definitely," said Cockerill.
"Like anything that’s had a strong run, you’ve got to be careful."
He points to single-country funds and trusts such as Aberdeen New Thai IT, which was up more than 1,000 per cent over a 10 year period at one point earlier this year, as other areas of concern. The trust has suffered a severe correction of around 25 per cent in the last month or so, though cumulative returns over the long-term remain strong.
Performance of trust vs indices over 10yrs
Source: FE Analytics
"Should investors expect a trust like this to do as well over the next 10 years? I don’t think so," said Cockerill. "This trust came from a very difficult period in the late 1990s and early 2000s when valuations were very low, but that’s no longer the case."
Looking at it from the opposite point of view, Cockerill believes that natural resources and emerging markets – which have had a difficult three years or so – are two areas that present investors with compelling value at the moment.
In a recent interview with FE Trustnet, he defended investors who hold a position in the under-firing JPM Natural Resources fund, saying: "From a portfolio construction point of view, this is a fund that’s full of stocks that have gotten cheaper and cheaper."
"If you’ve got 4, 5, 6 per cent of your portfolio in this fund, then you’re going to see a big return when a bounce-back occurs, which is quite reasonable and even likely."
With regard to emerging markets, he added: "If you are prepared to be patient, the long-term story is clearly not going anywhere."
"Growth in emerging markets peaks and troughs and at the moment it’s troughing. That doesn’t mean it won’t come back."
"I recently spoke to Newton, which says there are big problems in China, so the market could go lower from here. It’s a good long-term story though, particularly at these calculations. It could be a good one for a monthly savings plan, because timing the rebound is so difficult."
