Personal Finance: The Jonathan Davis Column - Fund managers face the music

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The Independent Online
TWO THINGS in particular have transformed the way that investment managers do business in recent years. One is our ability, thanks to computing power and fast data transfer, to measure investment returns in far greater detail and with much greater accuracy than ever before.

The second development is a revolution in our understanding of the nature and incidence of investment risk - which is not of course the same thing as saying that everyone has learned how to manage it. (Case in point: the hedge fund crisis).

The seemingly inexorable rise of index-tracking funds is just one of the many manifestations of these changes. It follows directly from the appearance of detailed performance measurement services, which have demonstrated beyond all reasonable doubt that a large proportion of traditional investment managers have been paid far too much for trying (and mostly failing) to deliver what turns out to be nothing more than average or below-average performance.

Slowly but surely, pension fund trustees and investment consultants have been coming round to the inevitable conclusion that it makes little sense to pay such high fees to an active manager when you can guarantee average performance for a much smaller outlay.

One consequence of these changes is that most fund managers are now judged and rewarded on the basis of their relative performance - that is, by how well they do relative to the market as a whole or, in more sophisticated cases, by how well they perform relative to an appropriate benchmark (for example, one that allows for the risks of the investment strategy which is being pursued). This emphasis on relative or benchmarked performance is fundamentally changing the way that different types of investor behave.

Take a look for example at the different portfolio weightings of pension funds, life assurance funds and unit trusts. Pension funds are moving closest to a policy of either straight indexing or what is called "closet indexing" - which is a policy of keeping the shape of a portfolio very similar to that of the market as a whole, but taking a few minor risks at the margin, which (if you are a fund manager) you hope will justify your extra performance fee.

Analysis by Schroder Securities suggests that the trend of pension funds to hold roughly the same kind of portfolios as each other has accelerated over the last couple of years. So much so that it is now uncommon for a typical pension fund to differ in its sector weightings from the All- Share index by more than 10 per cent in any one sector. (In other words, if banks account for nearly 15 per cent of the index by value, as they currently do, then a typical pension fund will have somewhere between 13.5 per cent and 16.5 per cent in that sector, regardless of the price of the shares).

Interestingly, Schroders' analysis shows that pension funds which are managed externally rather than by an in-house team tend to be more willing to diverge from the current market index weightings.

As the main feature of the stock market's performance over the past three years has been the exceptional strength of very large companies, it means that most pension fund portfolios are now very heavily concentrated in the sectors that dominate the large cap sector of the market.

As the table shows, these are banks, pharmaceutical companies, telecoms companies and the large integrated oil companies. This has become something of a dangerous self-reinforcing trend: the more these shares go up, the more other fund managers feel they that have to buy them and the more they go up again - the very mechanism by which bubbles in market valuations are eventually created.

By contrast, the average unit trust still adopts a much more aggressive style, with below-average holdings in these dominant large-cap sectors and comparatively higher proportions of their funds in both smaller and more cyclical stocks which are less well represented in the FTSE 100 index of largest companies.

Most funds are still marketed on the basis of their ability to achieve superior results, particularly in the selection of stocks. Yet the data supports the view that their success in outperforming the market is no greater as a group than that of any other class of investor - which is one reason why tracker funds have been able to make rapid inroads into the market.

Within the unit trust sector, interestingly, there are quite striking differences between the investment profiles of the different types of fund. By and large, as my table suggests, it is income funds which have been taking by far the biggest bets against the index (what Schroders calls benchmark risk).

This is not entirely surprising since, by definition, income funds tend to be chasing high-dividend yields, and high-yield stocks in a bull market tend to occupy the lower reaches of the market capitalisation tables. Because they are, in effect, barred by their income needs from investing in certain segments of the market, income funds also tend have an over- large representation in traditional industrial and manufacturing sectors and struggle to make up their weightings in faster growing and more fashionable sectors such as media and financials.

If you look at the range of weightings held by unit trusts (the last two lines in the table), you can see how much greater the range between maximum and minimum sector weightings is for the income fund sector than for any other.

Is this a good or bad thing? The answer of course is our old friend: it all depends. The truth is probably that at the moment few investors (and not many more financial advisers) have any real sense of the types of risk that they are taking when they choose a particular unit trust. They would probably be surprised to be told that, if their objective is to match the market index, they are taking an above average risk by buying a typical unit trust. The rapid growth of index funds in the last two years does suggest however that the message about costs, returns and risks is slowly sinking in.

The view of Edmond Shing, the strategist at Schroder Securities, is that the market's bias towards large-cap stocks and index-weighted portfolios is likely to persist until next year. (If anything the start of European Monetary Union next year is likely to accentuate the trend, as investors in other European countries, as well as US investors, try to get up to weight in the main sectors of the UK market).

He makes the point that what many big institutional investors are doing by moving the shape of their portfolios closer to that of the main market index is swapping one kind of risk for another. They are reducing the risk that they will under-perform the main performance benchmark - which makes it more likely that they will keep their jobs - but increasing their sector risk by loading up on such a narrow range of stocks. This in turn must eventually produce a fresh opportunity for those whose funds are betting on outperformance in other sectors, such as small cap stocks and traditional "value" stocks.

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