July 2011
Risk was rewarded last year, but it won’t always be.
Performance matters, everyone knows that and nowhere is that more important than in fund management. Apart from multi-asset funds the aim of every collective investment vehicle must be to deliver a better return than the relevant index, or at least a relevant conventional market cap based index fund.
To achieve that aim an active fund has to take more risk, and that can be done in two ways, assuming the portfolio is only constructed from constituents of the index. The manager can either elect not to hold certain stocks that he or she thinks will underperform or he or she can hold larger weights in stocks he expects to do better.
Not holding some shares opens the possibility that something you don't own suddenly does very well. Anyone not holding Lloyds at the end of June would have missed its 7% gain in a week. The other possibility is that something you do own suddenly goes bad for a whole variety of reasons and leaves the fund in a worse position compared with an index fund that only has a modest position.
In any event both tactics increase risk as a trade-off for the expectation of higher return. Indeed, risk is the only variable that can be changed in this race so it not surprising that competing fund managers will progressively increase risk relative to their competitors to get ahead. This is fine while the market is rewarding risk, higher risk generates higher rewards. There are no prizes for being risk averse in a bull market. And there has been a strong one since QE started two years ago.
As a consequence high risk funds currently dominate the league tables. This has created the rather unusual effect that as group the IMA UK All Companies sector has outperformed the FT All Share index over the last year. In the year to the end of May the All Companies Sector was up 21.2% compared to a 20.4% rise in the FT All Share Index, and that is after costs.
This seems rather odd given that because the funds invest in the index they are the index. How can they beat themselves, especially after costs? There are two answers. Firstly, many funds in the UK All Companies sector invest outside the index. They could be in different asset classes like bonds, foreign shares or listed on AIM. In other words they pinch some beta from other asset classes.
The second reason for the outperformance of the sector over the index is down to simple arithmetic. The average return for the 300 odd funds in the sector is calculated as a simple average. In other words each fund, be it a £40 million or a £10 billion, one has an equal weight in determining the total. In a risk friendly world the small fund taking big bets on small stocks is likely to do very well against a large fund that more or less mimics the index. In contrast index returns are calculated on a weighted average basis. That means a modest return from a large cap stock may have a bigger impact than a stupendous performance from a small cap share. But that effect might be diluted in a large fund.
Over time of course these differences will be ironed out as the Market alternates between loving and hating risk. In the end long term returns will be determined by dividends, as it has done for the last 100 years, which is a low risk strategy. One day investors may tire of trying to judge the market's appetite for risk and just opt for an asset allocation strategy that delivers the returns of the asset class with the lowest possible risk. But it is not there yet