Detlef Glow, head of EMEA Research at Lipper comments on key stages of the fund selection process.
Since my colleague Jake Moeller, Lipper’s head of Research for the U.K. & Ireland, recently wrote about the reasons an investor might sell a fund, I thought it would be worthwhile to write about the initial fund selection. To find a suitable fund it is necessary that the purpose for which the fund is being bought is clearly defined and that investors know their preferred performance profile.
Once the decision to invest in a given asset type or sector has been made, investors have to find the fund(s) that best suit best their needs. Since in some sectors there are hundreds of funds available to investors, it is necessary to narrow the investment universe by using a quantitative research process to evaluate fund performance.
To evaluate the performance of a mutual fund an investor must compare the performance of the fund to the performance of the appropriate market and other funds with the same or similar investment objectives. This means an investor needs to compare apples to apples–or even better, green apples with green apples and red apples with red ones–to employ a proper quantitative screening process. Even though this sounds very simple, it is a rather difficult task, since investors need to take into account that funds with the same investment objective might use different techniques (such as hedging strategies) to achieve their goals. To find a proper classification becomes even harder, when one is looking at alternative UCITS or multi-asset funds. These funds might have the same investment objective but employ totally different sources to generate returns, meaning that the funds might contain totally different risk factors. In this regard, it is important that the investor not only looks at the asset type and investment objective when he tries to classify a fund, he also needs to look at the performance and risk drivers within the portfolio. The fund prospectus is only a starting point for the fund classification, since the prospectus gives the investor only a general idea of what the fund manager can or can’t do to achieve particular goals.
The second step must be to view a detailed presentation, since that is the only way to understand what the fund manager is doing, especially in regard to rather complex products. In addition, one needs to monitor the holdings of the fund to see if there is any style drift and/or change of investment focus within the portfolio.
Even though past performance is no guarantee of future performance, past performance is the only source telling an investor how a fund has behaved in different market environments. Past performance is the only source for evaluating the risk/return profile of a fund. It is necessary that the investor use a period with enough data points to show statistically relevant results. A number of investors prefer monthly data for a three- to five-year period, i.e., 36 to 60 data points, to evaluate the performance of a fund. Even though it seems this number of data points is rather small, this period might be more relevant to evaluate the performance of a fund than longer periods; the fund manager or parts of the process might change during longer periods, which would falsify the results of the quantitative research.