How to choose the best funds

Posted on: 23 June 2010 by Mark O'haire

Independent financial advisor Peter McGahan examines where to invest your money and analyses whether past performance can be any guide to guessing whether your fund will reign supreme.

Investment fundsThis is one of the most interesting arguments in the financial services marketplace. There is more noise around this subject than any other and the confusion that is created is fodder for the unscrupulous. This will be a reasonably technical answer so I apologise in advance.

However this one area alone is where most investors make the biggest mistakes with their investments and if understood properly investors could save thousands.

So how do you decide which is the best fund? There are two parts to any research and they are qualitative and quantitative research.

Qualitative is the face to face assessment of a fund and what they are actually doing to achieve the growth in the fund. This is essential in understanding what a manager is actually doing and if their processes are robust.

It is in the quantitative (the numbers!) analysis where most investors lose fortunes. Let me explain:

Quite often you will see a fund shown as being top over one year, two years, three years and five years. An investor at that point might think they now have a fund that is good over the short, medium and long term.

However they could be about to make a huge mistake. This fund could well have had a large spike in its performance over the last few months. They could have had an exposure to oil for example, and the fund might have a rocketed short term performance.

However those few months information is included in the one year performance showing they are top, but it is also included in the three year and five-year data which completely misleads the investor into buying the fund at exactly the wrong time.

If a fund has had a short term spike you would now be buying it when its most expensive.

To analyse whether a fund is a ‘good’ fund you would want to know if the performance is down to the skill of the manager and that the skill is transferable to future decisions the manager and team might make.

To do that its worth buying in the expertise of a specialist investment IFA who will be able to assess this. For example I would want to exclude small short term spikes and I do that by assessing a fund on a discreet monthly basis ie each month gets its own score. This means that any spikes only have a good score in that particular month.

It is also worth assessing how much risk a fund is taking to achieve an objective. If a fund returned 50% in a year by taking a risk of 8 (crude measure I know) and there was a fund that took a risk of 6 but returned 48%, which would you choose? Which is offering the best value? The downside risk is much greater yet there is little out performance.

Risk is all about the potential for loss and potential for gain. They are in equal measure. A good investment IFA will be able to assess risk via a range of processes such as (bit of science now) standard deviation and Sharpe ratio for example.

Standard deviation measures the average performance per month and how much the fund deviates away from that average. Sharpe ratio calculates the risk a fund is taking and whether there is out performance for that risk.

By assessing this, an investment IFA can assess whether or not you should be investing into a fund and will ensure you avoid the mistake that both investors and many financial advisers make of buying a fund at completely the wrong time and losing your shirt.

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