Funds v Direct Equities
Here we ask some key questions that need considering before an investment manager makes the decision to build a portfolio exclusively with funds or direct securities or as is often the case, a mixture of the two.
Use the questions below to write down your thoughts before referring to the answers at the foot of the page.
You manage portfolios with a placement value of £100,000 to £500,000 for wealthy individual private clients.
a) What are the advantages and disadvantages of passive or active managed funds rather than individual securities for these clients?
b) What are the key investment suitability criteria that you will be looking for when choosing actively managed funds?
c) What particular aspects do you need to be mindful of in the construction of the portfolio?
ANSWERS:
a)
Some advantages of funds:
- Obtain diversification cheaply.
- Lower cost of trading due to sharing investment cost with others.
- Share in specialist pooled vehicles that allow access to certain desirable risk exposures.
- Share in pools that contain other similar minded asset owners with similar investment goals e.g. activist funds, index tracking funds, socially responsible investment funds.
- Some funds may be exempt or use instruments that do not incur stamp duty.
- Some funds can be switched without triggering capital gains tax whereas direct holdings would be liable. Tax paid only on eventual disposal.
- Dividends paid within the fund may not be taxable unless paid out to unit/share/policy holders.
- Some fund vehicles are not charged Value Added Tax (VAT) on fund management charges.
- Some disadvantages of funds
Some disadvantages of funds:
- Not bespoke or tailored.
- Adds at least one further layer of fees/charges.
- Lack of transparency of unit pricing methodology, commission sharing arrangements, time of day when valuations are struck, revenues and risks around stock lending and whether class action settlements are taken-up.
- Principal – agent problems concerning poor investment decisions, mismanagement and even fraud.
- Pooled funds experience net cash inflow or outflow which a wealth manager invested in has no control of. If such flows affect the cash holdings of the pooled fund then beta will fluctuate as the percentage of cash held by the fund fluctuates. If money flows into pooled funds when expected stock returns are high (i.e. at or near their low inflexion point), and if managers take some time to allocate new money according to their usual investment styles then the funds will have large cash holdings at times. Large cash holdings imply low betas at a time when expected returns are high.
- The effects of new money flows on a fund’s beta will depend on the magnitudes of the flows, the size of the asset holdings, and the speed with which new money is invested. Research evidences a strong correlation between net cash flows and concurrent stock market returns, suggesting a connection between cash flows to funds and expected returns.
b) Investment suitability criteria when selecting actively managed funds will include:
- Quantitative assessment such as the Sortino ratio, Sharpe ratio, Treynor measure, Jensen’s alpha, Appraisal ratio and Information ratio. Consistency, stability and durability of return generation and risk management.
- Qualitative measures, including financial strength of fund, seasoning, and assets under management. Investment philosophy, investment style, costs, charges, how active, quality of cash management.
- Regulatory history, tax and current regulation, including regulatory protection of the fund.
c) Particular aspects to be mindful of in the construction of the portfolio when using funds include:
- That the funds when combined do something other than obtain a beta of 1. A fund of funds can easily tend towards a beta of 1 because it is an overall average.
- It is essential that the funds when combined really do diversify. Real ex-post diversification needs to be achieved and not ex-ante diversification.
- Ensuring that differing funds are actually uncorrelated in practice requires analysis of good data on prior performance as well as knowledge of the stability of the investment approach and process. Of particular importance are the covariance and the marginal contribution to overall portfolio risk.
- If the funds do own some similar securities it is important that the risk and return of the funds remain significantly different from one another.