How to spot the best and worst funds out there

There are certain trends that should set alarm bells ringing

ATTEMPTING to identify sector trends is an investment strategy all experts strongly advise against. After all, past performance cannot be an indicator of future returns. But this is not the case when looking for a good fund manager.

A recent survey from Chelsea Financial Services (CFS) showed the worst performing funds – compared to their sector average – of the past three years. The poor-performing funds (and thus managers) include Manek Growth (52.98 per cent underperformance from sector average), UBS UK Smaller Companies (37.97 per cent underperformance), and IM HEXAM Global Emerging Markets (35.67 per cent underperformance).

Avoiding poorly-performing funds is tough. First, investors must separate those that have given poor absolute returns because the market or asset class they invest in has gone through a period of weakness, from those that have underperformed their benchmark. Consulting reports like BestInvest’s Spot the Dog, which highlights the underperformers over a three year period, can be a good way to distinguish between the two.

The next step is to look at track record. According to Jason Hollands of BestInvest, “investors have to find a manager who is doing a good relative job of adding value in a sector market”. And Darius McDermott of CFS says that a manager who has outperformed his sector three out of five years “could be a good place to put your money”.

Fund managers will underperform for a variety of reasons, from poor stock selection to making the wrong macro-economic decisions. But there are more obscure reasons for poor performance. Factors like liquidity issues and the drag impact of cash positions can lead to poor returns. “If a fund takes large positions in illiquid, small company stocks and the market enters a period of stress, it may be difficult for a manager to exit these positions and effectively manage the portfolio,” says Hollands.

For this reason, investors need to avoid making snap decisions on ditching a fund before fully investigating why it has underperformed. And it is important to look at how long a manager has been running a specific fund, advises Adrian Lowcock of Hargreaves Lansdown. “He may not be solely to blame for a fund’s poor performance.”

But with most sectors losing out last month, where do the best opportunities now lie? Hargreaves Lansdown has released data on June’s top performing funds – a useful indicator of short-term trends. Despite May wobbles, eight of the top ten performers in June invested in Japanese equities. And a victory for Shinzo Abe’s party in the country’s upper house later this month will give the Prime Minister greater political potential to enact structural reforms. “Japan has huge debt-to-GDP, an ageing population, and some out-of-date work practices,” says McDermott. “A victory for Abe’s party will make Japanese equities an even stronger opportunity.”

If looking for exposure to Japanese equities, Hollands likes GLG Japan Core Alpha, although he also believes European large cap stocks, like Henderson European Focus, and US value funds, like GAM Star GAMCO US, offer good opportunities. And while McDermott still thinks UK equities look like good value, BestInvest recommends only investing in multi-cap funds that are diversified beyond the FTSE 100 – as the index has a large weighting to commodities.

Commodities and gold have suffered in recent weeks, but Lowcock thinks that “as they become cheaper, they will become more attractive to certain investors”. Hollands, however, worries that the yellow metal will continue to face negative headwinds. A rising dollar, perceptions that quantitative easing will slow – undermining the case for holding gold as a hedge against currency debasement – and the unattractiveness of a zero-yielding asset class against a backdrop of rising long-term bond yields have all hit gold prices.

Having a contrarian view of the markets can make sense. “The art of successful investing is, after all, to buy low and sell high,” says Hollands. Buying the market that has risen the most recently could mean you are chasing a train that has already left the station.