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."

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Recruitment Genius: Content Writer - Global Financial Services

    £25000 - £30000 per annum: Recruitment Genius: From modest beginnings the comp...

    Recruitment Genius: Web Developer - PHP

    £35000 - £40000 per annum: Recruitment Genius: From modest beginnings the comp...

    Recruitment Genius: Field Sales Consultant - Financial Services - OTE £65,000

    £15000 - £65000 per annum: Recruitment Genius: This is an exciting opportunity...

    Recruitment Genius: Loan Underwriter

    £18000 - £20000 per annum: Recruitment Genius: This is a fantastic opportunity...

    Day In a Page

    A nap a day could save your life - and here's why

    A nap a day could save your life

    A midday nap is 'associated with reduced blood pressure'
    If men are so obsessed by sex, why do they clam up when confronted with the grisly realities?

    If men are so obsessed by sex...

    ...why do they clam up when confronted with the grisly realities?
    The comedy titans of Avalon on their attempt to save BBC3

    Jon Thoday and Richard Allen-Turner

    The comedy titans of Avalon on their attempt to save BBC3
    The bathing machine is back... but with a difference

    Rolling in the deep

    The bathing machine is back but with a difference
    Part-privatised tests, new age limits, driverless cars: Tories plot motoring revolution

    Conservatives plot a motoring revolution

    Draft report reveals biggest reform to regulations since driving test introduced in 1935
    The Silk Roads that trace civilisation: Long before the West rose to power, Asian pathways were connecting peoples and places

    The Silk Roads that trace civilisation

    Long before the West rose to power, Asian pathways were connecting peoples and places
    House of Lords: Outcry as donors, fixers and MPs caught up in expenses scandal are ennobled

    The honours that shame Britain

    Outcry as donors, fixers and MPs caught up in expenses scandal are ennobled
    When it comes to street harassment, we need to talk about race

    'When it comes to street harassment, we need to talk about race'

    Why are black men living the stereotypes and why are we letting them get away with it?
    International Tap Festival: Forget Fred Astaire and Ginger Rogers - this dancing is improvised, spontaneous and rhythmic

    International Tap Festival comes to the UK

    Forget Fred Astaire and Ginger Rogers - this dancing is improvised, spontaneous and rhythmic
    War with Isis: Is Turkey's buffer zone in Syria a matter of self-defence – or just anti-Kurd?

    Turkey's buffer zone in Syria: self-defence – or just anti-Kurd?

    Ankara accused of exacerbating racial division by allowing Turkmen minority to cross the border
    Doris Lessing: Acclaimed novelist was kept under MI5 observation for 18 years, newly released papers show

    'A subversive brothel keeper and Communist'

    Acclaimed novelist Doris Lessing was kept under MI5 observation for 18 years, newly released papers show
    Big Blue Live: BBC's Springwatch offshoot swaps back gardens for California's Monterey Bay

    BBC heads to the Californian coast

    The Big Blue Live crew is preparing for the first of three episodes on Sunday night, filming from boats, planes and an aquarium studio
    Austin Bidwell: The Victorian fraudster who shook the Bank of England with the most daring forgery the world had known

    Victorian fraudster who shook the Bank of England

    Conman Austin Bidwell. was a heartless cad who carried out the most daring forgery the world had known
    Car hacking scandal: Security designed to stop thieves hot-wiring almost every modern motor has been cracked

    Car hacking scandal

    Security designed to stop thieves hot-wiring almost every modern motor has been cracked
    10 best placemats

    Take your seat: 10 best placemats

    Protect your table and dine in style with a bold new accessory