Forget funds that track the market and get flexible

To get the best out of your investments, employing a manager with an unconstrained mandate could be the key, says Jennifer Hill

Fed up with funds that just mirror the market? You can release your investment to go its own way through what are known as "unconstrained funds". Often tagged "dynamic", "focus" or "aggressive", such funds are not tied to an index: the fund manager has the freedom to hold what he or she thinks are the best investment ideas. Being freed from an index means the fund manager isn't held back by being forced to include less attractive stocks that can dilute returns.

For instance, Standard Life's £232.1m UK Equity Unconstrained fund, has returned 113 per cent since being launched five years ago. That makes it the best-performing fund in the UK All Companies sector over the past five years, according to data from Lipper. The sector average? Just 22.8 per cent.

Adrian Lowcock at broker Bestinvest says: "In the current climate, investors should be looking for fund managers who are able to add value and we currently favour those with flexible mandates and the ability to pick the right stocks."

But what are the key features of unconstrained funds and the stocks they are backing?

Set yourself free

Tracker funds, by their very nature, have to hold the constituents of a specific index, but even actively managed funds are tied to the index they measure performance against – and that can thwart performance.

Many portfolios have significant exposure to the largest 20 stocks in the FTSE 350, which account for 60 per cent of the index, yet at any given time more than half of these stocks will underperform the remaining 330. The average stock in the FTSE 350 has returned 6.7 per cent per year over the past five years on a total return basis (with dividends reinvested), while the FTSE All-Share index has climbed just 1.95 per cent. The discrepancy is because of the drag of large-cap stocks, such as Shell, HSBC and BP.

Peter Hicks, product director at Fidelity Investment Managers, says: "The real advantage of unconstrained investing is that the manager is able to select investments and their weighting in the portfolio based on conviction rather than index membership.

"This advantage applies equally to stocks the manager chooses not to invest in. For example, there may be stocks that have a high index weighting which the manager doesn't hold at all." By using the FTSE 350 Equally Weighted Index as its benchmark, the Standard Life UK Equity Unconstrained fund is not influenced by market weightings.

"I don't worry that I don't hold Shell," says fund manager Ed Legget. "If you're paying for active management, you should outperform the average stock on the average day, but most funds don't aim to do so."

Undervalued stocks

Managers with unconstrained mandates seek out stocks they believe are undervalued. Legget attributes his performance since launch to "the benefits of combining an unconstrained fund structure with our UK equity team's 'focus on change' investment philosophy". The result is a portfolio of "best ideas": companies undergoing a turnaround or those in unloved sectors set for a re-rating.

Ben Yearsley at financial adviser Hargreaves Lansdown, which has Legget's fund in its Wealth 150 of favourite funds, says: "If the market is in a trading range, the last place you want to be is a fund tracking the index, whether that's a proper tracker or a closet tracker. You want the antithesis of a tracker – a fund that can basically buy what the manager thinks are the best companies, which naturally leads you to unconstrained funds."

Legget's top holding, accounting for 5 per cent of the fund, is DS Smith, the manufacturer and distributor of paper and plastic packaging, which has recently undergone a management overhaul. It also owns BP (its third-largest holding, with 4.5 per cent of assets), which Legget believes is "materially undervalued". "There are uncertainties surrounding the [Gulf of Mexico oil] spill and litigation outcome, but over time the discount will unwind and, on a six- to 18-month view, I see a lot of upside," he says.

Be focused

Unconstrained funds tend to have concentrated portfolios – and that's a good thing, according to recent research by Ignis Asset Management. It found that the greater a portfolio's concentration, the greater the tracking error (the volatility of divergence between a portfolio's return and its benchmark index return), and the greater the investment performance.

That finding reflects an earlier study by Yale School of Management which shows that, like the UK, most US mutual funds underperform their respective index over time, while most focused funds beat their index. Ralph Brook-Fox, manager of the Ignis UK Focus fund, says: "Once the number of stocks in a portfolio reaches around 30, any incremental stocks contribute very little to the reduction of tracking error. In other words, beyond around 30 stocks, the benefits to risk of further diversification rapidly dwindle away.

"The return opportunity, however, increases with focus. This is because only the best ideas are included. Should these perform as the fund manager expects them to, the fund's performance will not be diluted by numerous lower conviction positions."

Standard Life UK Equity Unconstrained has just 50 stocks, while Ignis UK Focus, an £88.3m fund, typically has only 30 to 40 stocks. The latter has made 14.3 per cent over one year and 35.6 per cent over five, while the UK All Companies sector is up 13.4 per cent and 24.1 per cent, Trustnet data shows.

While concentration can be a good thing in the right hands, a poorly managed unconstrained fund will suffer badly when overweight positions are taken in underperforming stocks. "I'd only consider investing in an unconstrained fund of a well-experienced manager with a strong track record," says Darius McDermott, managing director of discount broker Chelsea Financial Services.

Don't be fooled by names

The term "unconstrained" can be somewhat misleading, with many funds without constraints going by different names. The key is how much freedom fund managers have.

Lowcock likes well-known managers with unconstrained mandates including Richard Plackett of Blackrock UK Special Situations, Nigel Thomas of AXA Framlington UK Select Opportunities and Sanjeev Shah at Fidelity Special Situations. They have returned a total 44.7 per cent, 39.7 per cent and 34.8 per cent respectively over the past five years and are in positive territory over the past year, while the FTSE 100 is down 0.6 per cent. McDermott also likes Axa Framlington UK Select Opportunities and tips Schroder UK Alpha Plus, managed by Richard Buxton.

Yearsley points to Neil Woodford's Invesco Perpetual Income as a fund that is unconstrained in all but name. "He was one of the few equity income managers not to hold BP," says Yearsley. "Bearing in mind this was the largest quoted UK company, it was a big bet to take. His performance since April has been stellar." From 1 April, the fund has risen 3.8 per cent against a 1.1 per cent rise for the FTSE All-Share.

Think long-term

Ongoing economic uncertainty, above-average stock-market volatility and short-term focus of most investors is throwing up attractive investment opportunities for long-term investors.

Shah – the successor to Anthony Bolton, Britain's best stock-picker – looks for anomalies in the price of undervalued shares, and this can result in underperformance over the short term, according to Lowcock. However, the fund is up 40 per cent over the past five years, comfortably outperforming the UK All Companies sector's 24.1 per cent return. Legget has held one of his best stock picks since launch. IMI, the engineering and pneumatics firm, has experienced sweeping management changes and is moving into high-growth, high-return areas. Its shares have surged from 410p to 790p over the past five years – up 92.7 per cent before taking account of dividends.

Mix it up

With their ability to invest anywhere, unconstrained fund managers tend to own a wide variety of stocks – helping to spread risk. While BP is exposed to litigation risk, other stocks owned by Standard Life UK Equity Unconstrained, such as Lloyds and Barclays (4 per cent and 3.2 per cent of the fund respectively), are exposed to the recovery of the British banking system. Similarities in their holdings can also point to stocks or sectors that are poised for growth – with industrials, financials and consumer stocks appearing firm favourites.

Ignis UK Focus has 19.8 per cent in financials, 19.3 per cent in industrials and 15.8 per cent in consumer goods. UK Equity Unconstrained has 37.7 per cent in industrials, 19.1 per cent in financials, 9.2 per cent in consumer services and 5.8 per cent in consumer goods. Around 4.9 per cent of its portfolio is in Cookson Group, a manufacturer of ceramic components for the steel industry, and it also holds stocks exposed to consumer spending, such as Debenhams, Dixons owner DSGi and housebuilder Galliford Try.

Meanwhile, Fidelity Special Situations is overweight in media, driven by "some attractive companies on low valuations". Shah says: "BSkyB is one of my key media-sector holdings: earnings growth remains positive, driven by addition of new high-definition customers. The bid approach from News Corp, if successful, is also likely to drive the stock."

Looking for credit card or current account deals? Search here