Maximising investment portfolio performance

Oggers wrote: »

The point of comparison is to gain an appreciation of how the funds are performing against their tracker, and whether the manager of that fund is worth his salt - Jensen's alpha and all that...

You say "performing against 'their' tracker".

The FTSE100 is a highly specialist index of companies, weighted by value so that 5 companies make up over a quarter of it. Due to the weighting, which most consumers would not want to replicate for their retirement portfolio, the performance is highly skewed to events in the industries containing a few giant companies (oil & gas, banks, big pharma) while avoiding other industries altogether (e.g. under 1% in technology, compared to 12% for the developed world index as a whole; nothing in car manufacturing because no major car manufacturers chose to list their company in London, and so on).

By focusing exclusively on the 100 companies described above (with over 40% allocated to ten companies and under 60% allocated to the other 90), the index excludes entirely the financial performance of the 2000 companies that are listed in the UK but don't happen to have a market capitalisation of over £4.5 billion. It also ignores the 93% of the world's companies which don't happen to have a listing in the UK.

I appreciate the funds have different objectives, and yes, all are predominantly UK.

There are a couple of obvious comments to make about that statement.

1) Most fund managers do not want to copy that strange asset allocation described above and so would not seek to compare themselves against what you refer to as 'their' tracker. They are not attempting to achieve what it achieves. If any of the 7 funds in your mix are not FTSE 100 trackers, it tells you that they deliberately don't want to give you the performance of the FTSE100 because it is not an objective that it makes sense for their investors to have, in terms of asset allocation across industries, company size or world regions.

Also, if building a retirement fund out of building blocks in some sort of balanced manner, one would traditionally include assets which are not just equity shares in companies; such assets include (e.g.) bonds issued by companies or governments around the world, commercial property etc. Whereas the FTSE100 is just a collection of equity shares.

So, it does not seem to be a particularly good 'benchmark' against which to weigh the performance of your retirement fund portfolio over the short, medium or even long term.

2) You say that the funds are predominantly UK. As mentioned above, the UK is under 7% of world stockmarket capitalisation; it is also under 1% of the world's population. The cost of things to you in retirement will be driven by market forces from all over the world, and a huge proportion of what we consume (in terms of end product or service, or global cost drivers which contribute to the cost of the product) will come from outside the UK. So it seems bizarre to have your retirement fund invested in funds which all predominantly invest in companies listed in the UK rather than those listed elsewhere.

Still, I guess you can invest in what you want, and benchmark to what you want, however inappropriate - it's a free country

Of course I don't know for certain which fund will do better in the next month, but over the past 5 months the monthly rate of return of one fund is appreciably higher each month than that of the other. Of course the old adage of past performance etc etc applies, but on the strength of this information, is it worth a punt that next month will show similar

No, it is not worth a punt on concentrating in just one fund. If you are going to do that, why not see which fund performed the best over the last year or five years or couple of decades (5 months seems an arbitrarily short timescale) and just buy that one specialist fund that happened to do the best? The reason not to do that, is that over time, different funds have different levels of performance and do not all move in the same direction at the same time ; that is why we (most of us) build diversified portfolios.

For example, say there are three funds in your portfolio. One favours investing in technology-driven companies, one favours banks and financial services, the other has a blend of industries. As you are going along from month to month having started your portfolio in the late '90s, you see the tech fund is going up faster. So when it comes to next month you put most of your allocation of new money into the tech fund. After a year, you are regularly putting all your new money into the tech fund and thinking you are doing nicely because that fund has given a better return percentage over every month for the last year, than the other funds.

Your other funds which have given lower month-on-month performance and have not had much new money added to it are now just 10% of your portfolio each and the tech-heavy fund is 80%. The date is December 1999 and you look forward to maintaining those high rates of return over the decade to come. Then the 'dot com bubble' bursts and the tech fund drops 80% of its value over the next couple of years while the others only lose a quarter of theirs. Overall your retirement fund drops about 70% (65% attributable to the tech fund and 5% attributable to the rest of the portfolio). You wish you had not been so overexposed to the one that appeared to be doing so well.

Having turned £100k into £30k with that 70% drop, you are now in a situation where you need to more than triple the value of your portfolio to get back to where you were. Getting £70k growth on a £30k portfolio is a difficult task, because it requires 233% growth and most funds only deliver less than 10% average per year, more in a good year but negative in a bad year. So it is a challenge that could take a decade or a lot more to achieve.

But after the period of dropping markets you see that the banks and financial services fund seems to have bottomed out and is now doing well. The fund manager has identified LloydsTSB and RBS and Barclays as having good potential. From March 2003 to July 2003, Lloyds shares have bounced back from 325p to 450p, almost 40%, in just four months. You have seen that the fund whose manager likes financial services businesses has done very well in those four months. You wished it was a bigger part of your portfolio. You start to put more of your monthly contributions into that fund at the expense of the others.

Those stellar returns on Lloyds don't repeat, because 40% every 4 months is clearly unsustainable. But banks and mortgage lenders are beneficiaries of the general improvement in markets and the end of the recession as we move back into growth. So each month the returns on funds that own a high proportion of banks, do a bit better than other funds, and you keep putting more money in. Over a period of four years since you'd identified in summer 2003 that the banking fund was a good one, it keeps shining a little brighter than the others in your portfolio, which you begin to ignore, to follow the superstar. This might be a way to turn your £30k back into £100k! You are excited!

By summer 2007, Lloyds share price has hit almost £6 from £4.50 when you first started to over-allocate to the fund that loves to hold it. It has paid £1 of dividends in that time, which got reinvested. So really it's £7 of value. If only you had cottoned on earlier, you think to yourself! You could have been buying more of that fund when it was it at the very bottom, you think, when Lloyds was at £3.25. The £7 from £3.25 in March 2003 was 115% growth in just 4 years. If only you had bought more. But you hadn't bought more, because in March 2003 you were following your philosophy and busy 'buying what had just gone up the most' (or fallen the least) which wasn't the banking fund it was the generalist one.

So, you mentally kick yourself, because 115% growth in 4 years would have meant you would have got half way to your 230% growth target needed to get back from £30k to £100k. Ah well. At least if I keep plugging away with this good banking fund, maybe I will get there in the end. It seems to get a few percent a year better return than the generalist fund...

You see that one of the banks in the fund, RBS, has just taken over a Dutch bank ABN Amro, for £58 billion. This is clearly where the big money is. You get a bonus at work so you can make a big extra pension contribution and you put 100% of it into the fund whose investment manager likes banks, because owning RBS and Lloyds and Barclays is a sure fire way to keep making gains, because you just saw that his fund outperformed the generalist fund by a little bit yet again last month. When you read in the press that the fund manager added Halifax to the portfolio, you really like that news, because you see that loads of people are borrowing money to buy houses at ever higher prices.

So there we are in summer 2007 and you have a pension portfolio mostly concentrated in banks and insurers and mortgage companies. You may be aware where this is going. Down the pan, is where it is going.

The bottom falls out of the banking sector in the worldwide 'credit crunch'. RBS's takeover of ABN was pretty much the worst-timed move in all of corporate history and the bank collapses, resulting in shareholders' funds being worth a pittance. The government puts in some cash to prop it up, taking 80% of the equity in the process and leaving the remaining 20% being worth a tiny fraction of what some investors (including your favourite investment fund) paid for it.

With the credit crunch, mortgage lenders such as Halifax are screwed. Lloyds, which is not totally screwed as it has less of its business in mortgages, is co-erced by the government into taking over Halifax. Northern Rock goes under and shareholders get nothing. In the US, the prestigious Lehman brothers goes under. It is the worst time to have allocated your long term pension portfolio to a fund that loved to buy banks.

Barclays avoids an RBS-style government takeover but only because foreign investors prop it up by injecting capital at a way lower price than your fund manager had been paying for Barclays shares when you put your pension into his fund each month. The government bails out Lloyds with some emergency funding to stop it and Halifax (which it now owns) going under. The Halifax shares no longer exist, having dropped in value, and been bought by Lloyds giving your fund manager more shares in Lloyds as a result of the takeover.

You thought it was good watching the Lloyds price go up from 325p in March '03 to 590p in Feb' 07 plus a pound of dividends. A good 4 year return even though you missed the start of it and only started over-allocating to the fund that held a lot of Lloyds when they were 450p. At 590p your fund manager was sitting pretty and you were glad that he was getting the lion's share of your monthly pension money. But allocating more money to one manager based on the short term outperformance was a disaster.

In 2011 I bought some Lloyds shares for 24 pence. I could have got them cheaper if I waited a further week. A 95% loss from their 2007 value. But your policy didn't just have you buying and holding them from 450p in 2007. You were deliberately buying more when you saw they were getting expensive, gleefully allocating more and more pension to the fund manager who would to take your money and invest at 450p, 500p, 550p, 590p. So, you didn't just lose 'only' 95% on Lloyds, you lost a lot more. Of course, the fund manager didn't only buy Lloyds. He also bought Northern Rock which lost 100%. But also had some that didn't lose so badly, like HSBC.

Maybe you would escape with only 80% loss, like you did with the dotcom crash. So again your largest part of the portfolio loses 80% and the smaller parts of the portfolio lose 25, 30%. Your £100k tech-heavy pension which had fallen to £30k in the dotcom crash, and then evolved into a bank-heavy pension which had recovered to £60k... is now down another 70% to £20k.

Basically if you keep piling into 'recent winners' it all looks very good...for a while... following 'momentum' of the markets. If something does well one day then statistically it will tend to do well the next day too and the day after that... until it doesn't. A change of direction is very painful because you no longer have a balanced portfolio, you have been gambling on that one fund being the very best for the long term, when actually 6 out of 7 times it will be one of your other 6 funds being the best, and it will cost you.

- as it has done for the previous 5 months - and thus worth investing more in the fund that appears (for now) to offer the better rate of return?

"It offers the better rate of return" is exactly the wrong way to look at it, jumping entirely to the wrong conclusion. It delivered the best rate of return. People thought that collection of assets held by that particular fund manager was valued too low at the start of the period you are reviewing, so they started to pay more for those assets, increasing the fund's value, and the price went up. That doesn't mean it offers the best value now.

What it 'offers' is the chance to pay more for something that used to be cheaper. Clearly, that is not a great deal for you sitting there with a prospective investment to make. You would need a time machine to go back and get it at the cheap price. What it offers, is forward looking. And you know it is volatile, as it just jumped up a lot so it could fall down a lot too. The forward looking 'offer' is just potential; a potential gain of the same amount or a potential loss or anything in between. What it delivered (gains from a price that was relatively lower than todays) is the past, and you missed it. Probably because you had been buying something else that had been going up the most, rather than buying things that were getting cheaper.

Buy low sell high is the way to make money. Not buy high sell low. Buying high, and concentrating all your money into one particular specialist fund, are two things that usually end up in the destruction of your wealth, rather than growing it.

So when you have new money available and 7 funds to choose from, you have a choice to put more into the one that is the largest in your portfolio, and make an even more lopsided portfolio, or put more into the one that hasn't just gone up the most, and bring it back to a balanced portfolio. The latter is the logical choice, if you are actually aiming to maintain a balance between different funds which offer different objectives and opportunities.

If it is a more cautious fund it will do less well in a super-positive market, but it will protect your capital in a less positive market. If it is a fund that focuses on US investments it will not do as well as the fund that focuses on Asian investments when Asia does better than the US for a couple of months. But that in itself is no reason to drop it or give up on investing in the US. Because at some point Asia will do worse than the US and you would be annoyed if you had skewed your portfolio to investing mostly in Asia at ever-more-expensive prices and ignore cheap USA, which was going to go up the most next.

grey_gym_sock wrote: »

what's more important are the overall percentages you hold in different areas. so if you keep putting £80 into fund A, £20 into fund B, eventually you'll end up with most of your money in fund A, which may make your portfolio very unbalanced. the important thing is to have sensible targets for the overall percentage held in each area/fund, and then to keep reasonably close to those targets. so long as you do that, it's no big deal if you swap monthly contributions around a bit.

Agree with this.