10 tactics when researching funds, investment trusts and ETFs

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Returning following a two-week break, Kyle is joined by colleague Sam Benstead for this episode. The duo run through what private investors should look for when researching funds. Topics discussed include charges, the trap of performance chasing, how to identify funds that take significant active bets, and the importance of not buying too many funds in the same sector. 

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly look how to get the best out of your savings and investments.

In this episode, Sam Benstead is making his final appearance on the podcast before he heads off to pastures new. As it's his final appearance, I was keen to extract for you as much of his knowledge about funds, investment trusts and exchange-traded funds (ETFs) as possible, and this is why we’ve devoted this episode to explaining our top tactics for what to look out for when researching collective investments.

So, Sam and I are going to cover five points each, starting with fund charges.

Now, when it comes to investing, there are no guarantees of a set level of performance, and there are no guarantees that you'll make a positive return. Although the history books do show that if you invest for the long term of at least five years, but ideally much longer than that, then going down the stock market route tends to grow your wealth more in real terms as opposed to leaving your money in cash. While cash is, of course, safer, it tends not to keep up with inflation over the long term.

However, Sam, one thing investors can control is costs, and this is why it’s very important to look at fund charges in respect of both active funds, those managed by professional investors, and index funds and ETFs, which passively track the up and down fortunes of a particular index.

So, Sam, I'll hand it over to you to explain the importance of looking at fund fees.

Sam Benstead, fixed income lead at interactive investor: Thanks, Kyle. So, as you say, cost is one of the main things that we definitely can control and I think when investors look at index funds, cost is especially important because often you might have two comparable products tracking the same index, and the only thing that really separates them is the cost.

So, there's two big index fund providers, BlackRock and Vanguard, and BlackRock's index fund group is the iShares division. I think a lot of people are drawn to these two fund managers for their passive options just because they are the largest and while they are brilliant fund managers, and they've been doing this a long time, there are some alternatives to tracking some of the biggest stock market indices that I think are worth considering.

So, I'll just highlight a few here, and we’ve seen these all be very popular in our monthly most-bought lists as well. So, the HSBC FTSE All-World Index fund is very popular. This tracks global shares including emerging markets for a low fee of just 0.13%.

For the US market, the SPDR S&P 500 ETF GBP (LSE:SPX5), stock market ticker SPX5, which is part of our Super 60 list, charges just 0.03% for American shares, and that compares to 0.07% for the alternative from BlackRock and Vanguard. So, very, very competitive there and vetted by our expert fund research team.

For the MSCI World, you can pay just 0.12% with Fidelity Index World, and that's an open-ended fund. If you wanted an ETF, you can pay the same fee for the SPDR MSCI World ETF GBP (LSE:SWLD) with the ticker SWLD. So, some great passive options there if you are very cost-conscious.

For active funds, a higher fee doesn’t mean a better fund manager and, actually, often the best fund managers are backed by great fund management firms, and they work really hard to keep fees low for investors.

So, three investment trusts really jump out to me for their low fees, but also excellent management, and those are Scottish Mortgage Ord (LSE:SMT), City of London Ord (LSE:CTY), and Capital Gearing Ord (LSE:CGT). So, very experienced fund managers there, great long-term records, and those fees respectively are 0.35%, 0.37%, and 0.56%. So, really, really good fees and great long-term performance.

Whereas from other active funds, if you’re looking at fees above 1%, I think you’ve really got to figure out why you want to back that fund manager.

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Kyle Caldwell: As Sam has explained, with fund charges, it’s really important to look for like for like. So, if it’s an index fund or an ETF, compare that index fund or ETF against others that are tracking the same market.

With active funds, it’s a case of looking at the sector or region that the fund's investing in and then comparing charges against competitors to see whether fees are lower, about average, or higher than average.

In terms of a typical fund charge for an index fund or an ETF tracking, say, the S&P 500 index or the FTSE All-Share, so a mainstream developed market, you can pay less than 0.1% a year as Sam outlines.

For an actively managed fund, so for an equity fund that’s investing globally or in the UK or Europe or the US, typically, the charge per year is going to be around 0.8% to 1%, and it’s what’s known as the ongoing charges figure (OCF).

For me, it's easy to overlook costs, especially when they are quoted as a percentage, but even a relatively small percentage difference can make a big difference in pounds and pence over the long term.

While a few percentage points of fees may not seem much over one year, over 20 or 30 years, they can seriously reduce your net worth if you are not seeing outperformance of an index.

For me, there's nothing wrong with paying a premium or paying more for an active fund, but you want to see performance delivered and add value for you over the long term.

We're now going to move on to the second item on our agenda, which is to look under the bonnet. So, in terms of looking under the bonnet, I think it's important for investors to find out how a fund invests, look at its top 10 holdings, compare those holdings with the index, have a look at how the fund has performed versus a comparable index over different time periods such as one, three, and five years.

Now, if you notice that the performance line of the fund is quite similar to the index, this could be a sign that the fund manager is not taking enough active bets, so not investing differently enough from the index. One metric that some fund firms publish is what’s known as the active share ratio. Now, unfortunately, it’s not widely available and fund firms are not mandated to publish this ratio on their fund factsheets or on other marketing literature. But it’s a very useful ratio when it is published to show how active the fund is.

So, if a fund has an active share ratio of over 80%, that tends to show that the fund manager is investing very differently from the index.

If I'm being cynical, if a fund firm is not showing the the active share ratio, then I'd potentially question why that’s the case, and ask whether the fund is being active enough.

So, we've already spoken a lot about active funds versus passive funds, index funds, and ETFs. Now we’re going to come on to our first tactic, which is to mix and match between the two fund types.

For me, I think some people are far too dogmatic in taking one side over the other. Of course, there are a lot of vested interests on both sides of the arguments about whether to entrust a fund manager or whether to simply own the market through an index fund or an ETF. But, for me, it shouldn't be an either/or decision. They can both work well alongside each other in a portfolio. 

Sam, over to you to explain how blending the two approaches can give investors the best of both worlds.

Sam Benstead: Yeah, I think that's the right way of looking at it. There's no reason to just select passive or just select active.

In my personal portfolio, I've got a mixture of active and passive funds. As a broad point, I say passive funds are great at capturing a market, and if you want exposure to global shares or US shares or UK shares, the simplest thing to do is just own passive, and most of the research in most markets points to passive funds outperforming active funds over the longer term.

That's not to say that active funds won't outperform, but generally, you've got a better chance of winning in the stock market with a passive fund than trying to select one of the very many active funds. Not to say you can't do it, but the odds are probably in your favour if you go with a passive fund.

But actually, if you look at the way passive funds are made up in the main markets at the moment, you'll see that they're quite concentrated in US shares. So, the global MSCI World Index is about 73% in US shares. Eight of the largest US companies are now in the tech sector.

So, it really is looking more and more like a bet on the US and the tech sector, specifically if you own a passive fund. That’s been a great winning thing for markets over the past 15, 20 years, but it does contain some hidden risk.

One way of thinking about the active/passive combination is to balance your passive funds that are quite tech-heavy with an active fund, which actively seeks to own cheap shares, for example. So, a global tracker fund, but the value funds also looking at global shares could be a really neat combination.

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Kyle Caldwell: As well as costs with index funds or ETFs, it's also important to look under the bonnet and check which index the fund is aiming to replicate. For example, there are a number of global equity income ETFs that track various different indices. Because of this, the difference in performance can be quite stark.

I last wrote about this around a year to 18 months ago, and I was really surprised to see how wide the gap was between the best performer and the worst performer over three and five-year time periods. This is because some of these global equity ETFs follow the up and down fortunes of a basket of shares that are filtered based on a certain level of dividend yields.

Some of them focus on dividend track records, so companies that have grown their dividends consistently over a certain number of years. For example, over six, seven, eight years or more. And some ETF providers use indices. So, when I say indices, it's a selection of different companies that have been screened for different criteria. Some of them use indices that they've actually built themselves.

So, it's really important to look under the bonnet with index funds and ETFs, as well as examining the fund fee, and checking out which particular part of the market its tracking, before making an assessment on whether you want to gain exposure to that area or those particular group of companies.

However, when it comes to research and funds, I think it’s fair to say that it’s simpler to buy an index fund or an ETF. If you buy an actively managed fund, there's a lot more factors that you need to consider.

Number four on our list is to consider how long the fund manager has been running money for. Like anything in life, experience counts for a lot.

So, fund managers who have been around the block a couple of times, they’ll have witnessed a number of market cycles, and be able to draw on their experience, including learning from any past mistakes.

Now, of course, a newcomer, a fund manager who’s been running money for a couple of years, they could come in and do a great job. In the case of younger fund managers, they [won’t] come in and be completely new, they'll have had several years’ experience as an analyst prior to making the step up to run money. In addition, there’s much more of a team approach nowadays.

Long gone are the days of the staff or manager culture. Although, I do think, particularly for retail investors, that it's very important that there’s a key decision-maker and that there's credibility, accountability and that there’s a figurehead who explains why performance is not up to scratch if the fund’s having a bad spell.

However, do bear in mind that with experience and fund managers, the past is not always [a guide to the future], and there have been cases where veteran fund managers have had the best years of performance at the start of their careers when they've been running less money, which means they can be more nimble and move in and out of stocks quicker.

Sam Benstead: They might have had a lot of success at the start of their careers, and actually, 10, 15, 20, 30 years later, markets have just fundamentally changed, and the way they want to manage money and the way they were brought up doing it, just doesn't work so well anymore, and they haven't been able to adapt to new market environments.

Kyle Caldwell: One final point for me, Sam, is the reassurance of seeing a fund manager in the same post for a long period of time of, say, 10 years-plus. As you would think, if they’ve been in that post for such a long time, then potentially it’s been very good performance that has kept them there.

We'll now move on to number five in our list of tactics to look out for when researching funds, and that’s not to buy every fund you like the look of.

Sam Benstead: Absolutely. I think this is a really, really important one. When I started out interviewing fund managers seven years ago or so, everybody I spoke to was so persuasive, and I wanted to go home and buy their funds immediately.

But I think it's really important when you are reading fund commentary or listening to podcasts with fund managers, or watching our videos, that you do make a choice about what’s right for your portfolio, and you don't just try and buy a little bit of everything because the fund manager speaks very confidently and passionately about the market they are investing in.

Almost all fund managers will say it's a great time to buy their market, and that's something that Kyle and I have experienced and always try and push back against.

Because they are salespeople, they're running money, but they're also trying to gather assets as well. So, it's very important to look at their fund and think about how it might fit into your portfolio. Think about whether you already have an active or a passive fund, which works in that market. Do you really want to switch out funds to buy it, or are you going to hold both of them at the same time?

So, asking those questions is really, really key. And if you don't do that, you might suddenly end up with 30, 40, 50 funds in a portfolio, each with 50 shares. And at that point, you might as well just own a passive fund.

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Kyle Caldwell: Completely agree, Sam. If you've got over 15 or 20 funds, you should really take a hard look at your whole portfolio and consider whether every single fund is bringing something different to the party and earning its keep and adding value to your portfolio.

As Sam mentioned, if you own a number of similar funds, say, you own five, six or seven that invest in the UK, you end up owning hundreds of shares, and your portfolio then ends up looking like the wider market, and it’ll perform like it as well. If you want to own the wider market, then that can be achieved more cheaply through an index fund or an ETF.

Sam Benstead: A good way of controlling the portfolio could be to do an annual review. You can look at which funds have done well, and which have done poorly. You could perhaps rebalance, and then just think over the next 12 months or 24 months about the sectors and markets that you might want to own, the ones that you find interesting, and then go from there and try and build a clever portfolio that you can then stick with for a year or so.

Kyle Caldwell: This leads me on to item number six on the list. So, as part of a review of your portfolio, say once or twice a year, it's important to watch out for fund manager changes.

With active funds, there’s the prospect of the fund manager or the whole fund management team jumping ship or being moved on internally and replaced by another fund manager or team. This does pose a problem for investors with regards to whether you should follow the fund manager out the door or put your faith in the new manager or managers who are taking over. For me, it’s important to assess key person risk.

I’ll consider whether one fund manager has been highly influential in calling all the shots or whether it’s been more of a team approach with a couple of named co-managers or deputy fund managers. If it’s been one fund manager who appears to be calling all the shots, then their departure to another firm or their retirement is arguably more of a blow.

Another important thing to consider is whether under a new fund manager, the investment objective and approach could change. Now, in most cases, the investment process remains the same as they want to keep investors on side. But if that isn’t the case, then it’s no longer the same fund as when you bought it.

So, it’s time to consider whether to keep it or move on. Now, a fund changing its investment approach is not necessarily a bad thing. There’ll be a reason for the change, and that change in approach could lead to improved performance. However, if the fund’s not doing what you want it to do, it’s probably time to sell.

To give you an example, if you bought the fund for its income purposes and then it changes to no longer paying income, or the amount of income it’s paying reduces quite markedly, I would consider moving on.

Performance is also a very important thing to assess when you're researching funds. However, when considering introducing new funds into your portfolio, there’s the danger of performance chasing, which is number seven on our list of tactics.

Sam, I’ll pass the baton to you to explain.

Sam Benstead: So, I think this is something that a lot of investors get wrong initially when they start buying funds. They look at annual reviews, quarterly reviews or research pieces looking at the best performance over the past three or five years or so, and they think, ‘Wow, that fund’s doubled its money for investors last year, I want a piece of that. If only I’d invested a year ago. If I invest now, it might do the same.’

I think during the pandemic, a lot of investors, particularly first-time investors, but also experienced ones, looked at the amazing returns from technology shares in 2020 and early 2021 and piled in at the top of the market, and they are yet to recover what they invested. I think that’s a real warning sign, as we’re told so often, past performance does not indicate future returns, and this is incredibly true. So, looking at the best performers over the past couple of years is actually a very dangerous thing to do.

Kyle Caldwell: It goes back, again, to looking under the bonnet and assessing why that fund’s performed well. Has it been a favorable backdrop for the way the fund invests, for its investment style? Or has it been a favorable backdrop for the theme or sector it invests in if it’s specialising in a certain area?

The thing I think about when looking at a strong-performing fund is to try to remember that the fund has delivered strong returns for other investors rather than myself. And it’s then assessing whether over the next three to five years or longer, that level of return will be sustained.

I’m taking a view on whether performance will continue to be as strong as it has been over the past couple of years.

Sam Benstead: Definitely. I’d look at a factsheet if a fund’s done really well. If it’s a growth-focused fund, look at the size of the top positions.

If NVIDIA Corp (NASDAQ:NVDA) has doubled over the past year and it’s the top holding at 10%, or, like in some investment trusts [during] early 2020 and 2021, when Tesla Inc (NASDAQ:TSLA) became a very large position, that would be a bit of a warning sign.

If a company’s done extremely well and it’s still the [top] position, it shows that they expect it to keep going up. And often, with companies, a long run of strong performance is followed by, a less-good run.

For a value fund, a lot of factsheets will put the price to earnings ratio of the portfolio on there. If a value fund is starting to look expensive, and for that, I might say if the earnings ratio is kind of in line with the market, so that's about 14 times for the UK market at the moment, for value funds, it's starting to look expensive. That means they're holding a lot of their winners.

With a value fund that’s done well, I like to see a cheap portfolio still, meaning that they’ve sold their winners and they are reinvesting the money back into cheaper shares.

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Kyle Caldwell: And as ever, diversification is key. If you invest in different assets, different fund styles, different regions, then over time, some investments will do better than others. Over the long term, this should smooth your returns, which helps to keep a lid on risk. As well as smooth returns, it also gives a portfolio ample opportunity to grow.

As well as the dangers of buying a fund on a hot streak of form, with investment trusts, there’s also the risk of buying on a premium, which is number eight on our list of tactics to consider when researching collective investments.

For those not as familiar with the investment trust structure, investment trusts trade on a premium when their share price is trading above the value of their portfolio, so the value of the underlying investments, which is known as the net asset value or NAV. When that's not the case, when the share price is trading below the net asset value, then an investment trust is trading on a discount.

Now in the case of premiums, as a general rule of thumb, I would urge caution about investing in any investment trust trading on a premium of over 5%, and certainly over 10%. This is because over time, there have been various examples of high premiums being unsustainable and, over time, market conditions change and investor sentiment can also change, which can have lead to premiums cooling.

When premiums do cool, that hurts the share price total return. One sector that’s a case in point is the renewable energy infrastructure sector. So, before interest rates rose from rock-bottom levels, this sector was very popular with investors. As a result, most, if not all, the trusts in that sector were trading on a premium.

However, at the end of 2021, renewable energy infrastructure trusts were trading on an average premium of 7.2%. At the time of this recording in early August, the average trust in that sector is now on a discount of 24.5%. That’s a really big move, and it hurt the share price total returns of investment trusts in that sector.

I won’t go into too much detail now about why that sector’s been out of favour, but the main reason has been rising interest rates, which meant investors were looking to dial down on risk. They’ve been eyeing up safer alternatives such as money market funds and, as renewable energy infrastructure trusts pay a high level of income, they’ve been less attracted to taking on risk to achieve a higher level of income.

With investment trust discounts, I just want to make the point that while discounts do offer investors the opportunity to potentially pick up a bargain, it's important to remember that investment trust discounts tend to converge to the mean discount rather than to the net asset value. That’s something to bear in mind.

So, if you see an investment trust on a discount of, say, 15%, that doesn’t necessarily mean that over time the 15% discount will be eliminated. That particular discount of 15% could be the same as its five-year average discount figure. So, it's not necessarily a bargain in that particular case.

Let's move on now to number nine on the list, which is to be wary of being seduced by a compelling investment story, trend, or theme. Sam, over to you to explain.

Sam Benstead: This one is really important, and we’re talking here about thematic funds. These are funds that own shares that all align to a certain investment theme. So, it could be artificial intelligence or cybersecurity or uranium. They all have companies that should do well if that type of market is performing well. But, actually, the reality is that thematic funds generally don't make good investments.

Research from Morningstar, published recently, found that over the past five years, only 20% of thematic funds have beaten broader indices, and that's according to data looking at thematic funds versus the MSCI World, if that's applicable to them, or the S&P 500, if that’s the most relevant index for the thematic fund.

So, four in five not outperforming simple tracker funds, and Morningstar found that the worst culprits were thematic funds in the life sciences, wellness, nanotechnology, and food sectors, and it even found that AI funds only just beat their respective indices over the past five years despite AI really, really taking off.

So, you would have done as well out of AI by just owning the US index over owning a dedicated AI fund, which I think is really interesting.

There is one exception. So, defence thematic funds have done amazingly well recently. But for me, it could be a sign that they are going to go through a less-hot period in the future.

But I do think thematic funds have a place in portfolios if you’re using them instead of picking your own shares to get exposure to a theme. So, with just one ETF, you can pick up a basket of shares involved in a certain theme, and that’s a far more efficient and less-risky way of picking your own shares to try and build a diversified exposure to an investment theme.

Kyle Caldwell: I completely agree, Sam. I think a thematic fund can certainly have a place in a well-diversified portfolio, but the thing to remember is that investing in a long-term theme is over the long term, so you need to adopt a long-term mindset and approach. There’s the danger of spotting a theme a bit late on and buying when valuations are high. I think this is a particular problem if you invest over the short term as opposed to investing over long term of, say, five to 10 years-plus.

Sam Benstead: That valuation point is really relevant when the thematic fund is new. Fund management groups, as we know, are out there to make money, and if they pick up on interest from investors in a certain idea, they are then going to be rushing to build a product that they can sell. That might take them six months to a year and by that time, it might be the top of the market, and you’ve missed the really big run-up in share prices.

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Kyle Caldwell: Good stories don’t always make great investments. Another very short point I want to make is about the importance of being aware that stock market and economic performance are not always aligned.

For example, high economic growth for an emerging market country does not always translate into strong stock market returns. On the other side of the coin, just because economic growth in a particular country or region is sluggish doesn’t mean that it’s not going to make a great investment over the long term.

One example is Europe. If you invested in Europe three to five years ago and invested in the average funds, you’ll have made a very good return despite all the noise about how economic growth in Europe is very sluggish and the outlook economically looks bleak.

Finally, last but not least, 10th on our list is to position size-appropriately. What I mean by this is to not have too much exposure to one particular fund.

For around a year, I was writing a column for the Telegraph called ‘Rate my Portfolio’, where Telegraph readers would send in their portfolios and ask me to share my thoughts on their portfolio. In a few cases, I saw portfolios where the reader had more than 50% in one particular fund.

In some cases, it wasn’t like it was a multi-asset fund, where you could theoretically have the lion’s share of a portfolio in it. In some cases, it was one fund investing in just one region and not globally either. So, it’s important to avoid putting all your eggs in one fund basket - I’ve just coined a new saying there.

It’s also important to avoid having too many holdings that are too small and therefore too insignificant to make a difference to your overall portfolio returns. If you have a holding of, say, 2%, or less than 2%, in one fund, the chances are it’s not going to move the performance dial either way even if it performs very well.

Sam Benstead: Yeah. That’s a really key point, especially if a fund has done really well and it might have gone from a 5% to a 10 % to a 15% stake in your portfolio. Actually, that might not be suitable for the type of fund that it is. So, yeah, it’s really important to keep an eye on position sizes, particularly if you’re investing in a niche theme, sector or market rather than a really diversified global option.

Kyle Caldwell: I completely agree, Sam, and it goes back to the points made earlier about regularly reviewing a portfolio once or twice a year and rebalancing, which involves selling some of your winners when they have a strong period of performance.

Rebalancing allows you to maintain the same risk profile for your portfolio as when you first put it together, and it’s a very important way to keep a lid on risk and not have a portfolio that becomes too risky for your needs and objectives.

That’s all we have time for today. My thanks to Sam, not just for today’s episode, but for his various podcast appearances over the years and helping to get educational information across in an accessible manner.

And thank you for listening to this episode of On The Money. If you enjoyed it, please do follow the show in your podcast app and do tell your friends about it. If you get a chance, please leave a review or a rating in your podcast app too.

We'd love to hear from you. You can get in touch by emailing OTM@ii.co.uk. In the meantime, you can find more information and practical points on to how to get the most out of your investments on the interactive investor website. I’ll see you next week.