Unit trusts: Bamboozled by choice

Freelance writer Leon Kok writes that he is beginning to feel increasingly concerned about fund advice given to the average investor. Not only is he or she bamboozled by the choice of 500 plus unit trusts, but has to decide between large investment houses versus boutique asset managers, funds of funds versus single management funds, general funds versus specialized funds, and managed funds versus passive funds.

Competent investment advisors are certainly a necessity in such situations, they in turn are subject to the Financial Advisory and Intermediary Services Act (FAIS) which provides relative protection to the investor, but in the end as many views are likely to arise as there are advisors.

The question begs: What's the best view? Not easy to answer. Much will depend on the investor and/or his advisor's biases. This became much more apparent to me when abroad recently than I've generally found at home. Main reason is that South Africans have only superficially engaged in these debates.

One exception perhaps is large investment houses versus boutique managers and I'll leave that other for further discussion in the future.

At one end funds of funds claim that over the longer term they have a far greater prospect of outperformance than single manager funds since they tend to be well diversified. For this reason, they believe, they have a far lower correlation with any particular market and therefore have a lower beta. The flip side is that they grossly underperform in bull markets and whatever performance they do offer is shaved by the double fees that investors have to pay - on the funds of funds and on the underlying funds.

At the other end proponents of single manager specialist funds argue that the ability to select these more than outweigh the extra layer of costs. Take the example of a global equity portfolio manager investing in Asia. Only a regional specialist would have access to, say, Japanese small caps. If that sector were enjoying a growth spurt, a multi-manager or generalist manager would miss out on the alpha produced.

Focused fund managers believe that they can outperform the market not only by what they invest in, but what they don't invest in. Because they can focus on a handful of companies, typically 30 or less, these funds managers usually know and track their holdings far better than funds that invest in three or four times the number of shares.

As Donald Yacktman, whose $100 million Yacktman Focused Fund that has consistently outperformed the S&P 500 Index told the Financial Times, "Why would you want to put your money in your 50th best idea?"

The FT points out that because focused fund managers believe in their shares, they trade them less frequently than diversified fund managers, keeping turnover low. Just as important, these managers can avoid large mature shares that weigh heavily on most indices, such as Microsoft, a venerable company but which may no longer promise the kind of growth that that will drive future returns. Many focused funds also avoid momentum stocks and look to buy on the cheap.

The case against focused funds is that investment in them does not guarantee outperformance. They tend to be more volatile than, say, general equity funds and can suffer from more exaggerated short-term declines.

The case for typical diversified equity funds, on the other hand, is that their performances follow a bell curve, with the bulk delivering average returns, and a small percentage delivering exceptional and poor returns.

The case for managed funds is that you aren't just acquiring shares in a portfolio when you put your money in a fund - you're also paying for top-notch management that presumably has shown a consistent ability to beat the market.

In contrast, an index fund is a broad measure of a given stock exchange universe and though it will probably never be the number one fund, it may have a good chance of winding up in the top half. An index fund is designed to replicate rather than beat the market which at worst is better than not beating the market. A further advantage of index funds is that they're low cost.

Translating this into a South African context with admittedly still very little underlying data to go with, the top five single manager equity funds have handsomely outperformed their multi-manager counterparts over both one and five years. The best of the single manager general equity funds, arguably, is Investec with a 40% return on 12 months and a 160% return on three years, or Allan Gray General Equity with a 48% return on one year and 132% on three years.

The best of the multi-managed funds, in contrast, is perhaps PSG Alphen Equity with a 33% return on one year, and 125% on three years.

Comparing the best general equity funds with the best specialized funds creates somewhat of a dilemma. The Investec Value Fund and the Sanlam Small Cap Fund, for example, are significantly down on the best general equity funds over 12 months, but have beaten them handsomely over a three-year period.

Turning to the managed versus index funds, you would have been well- rewarded if you had invested in the best managed funds, but on a one-year period the Stanlib Index Fund was the seventh best performer among 46 funds general equity funds. So what were you paying for by being invested in the remaining 39? Not to mention your advisor's fee. Think about it.

Leon Kok writes for publications in the United Kingdom, the United States and Switzerland, in addition to local periodicals such as Finance Week. He writes in his personal capacity and views and comments should not be considered to be advice. If you are unsure which unit trusts to invest in please consult a financial advisor.