Making the most of increased transparency

There is currently more data available on manager performance and positioning than at any previous point in history. At almost the push of a button it is possible to view a manager’s historic performance versus indices and peer groups, the latest sector positioning, top 10 holdings, style and a range of risk-adjusted statistics.

With this background you would expect the job of a fund selector has become easier, but while the increase in data has levelled the playing field, and eroded the information advantage available to some, the fact that these information sources are now industry standard has actually increased the difficulty of selecting a manager.

Although the above criteria are good ways of performing a fund search, they are all backwards looking. Before investing, a selector needs to understand the manager, his experience and what drives his investment decisions. Is the manager motivated, both financially and mentally, and experienced enough to deal with difficult markets? Is there key person risk or a team in place? Is the investment process adaptable to market conditions? Does the manager and management house enjoy a good reputation? Finally is the fund structure suitable and reasonably priced for the end investors?

The process of gathering this information can be treated either as a tick box exercise or an opportunity to discover more about the manager – looking at how information is provided, how quickly and how comprehensively can tell you a lot about the experience you will have with an investment.

To incorporate the whole information gathering process into a robust and repeatable process can result in a distinct informational advantage for the selector.

AN ATTRACTIVE SECTOR

Despite best intentions, putting this into practice can be difficult, particularly in a competitive sector such as UK equity income. The UK equity income sector has historically been broadly split between those funds with a strict yield focus and those who concentrate on total return. Both types of fund have their place and are attractive to clients in differing ways, but what we have increasingly seen over the last year is clients who do not require an income being attracted to equity income because of the disciplined investment style.

We have witnessed those who follow a yield discipline being harder hit than their total return counterparts, post the 2008 crisis. The sudden decrease in the number of higher yielding stocks, particularly in the financial sector, left managers chasing a limited number of high dividend payers resulting in a higher exposure to stock specific risk than had historically been the case (for example BP).

These fundamental changes have cost the sector dearly, with a number of managers leaving their long running products. Those who remain have had to make changes in the way they run money in order to survive. There has been increasing use made of covered call options, some barbell strategies have become more extreme in order to maintain both capital growth and income, and several managers have rebased their dividends to reflect the new environment.

As a fund selector it is important to recognise that while the defined universe of UK equities has not changed, the risks at the product level have significantly altered with the result that past performance must be closely scrutinised and managers’ ability to use new tools must be questioned. The risks within what was a relatively dull part of the sector have undoubtedly increased but it remains an important allocation for clients who require a level of income.

Managers with a total return mandate have experienced a less torrid time, having the flexibility to sacrifice some of their prospective UK Equity Income written by DaviD McFaDzean yield to gain growth opportunities has largely led to a smoother ride for investors. Despite this they now face a new set of challenges, where their traditional core defensive holdings have been bid up to high levels.

This multiple expansion may be uncomfortable for a naturally conservative sector, but with a dearth of yield available elsewhere in many cases it looks justified. Selectors are well aware that the initial purchase price will have a significant impact on the long-run returns and focusing on finding managers who are valuation aware and have experience in managing through market cycles is crucial. In the short term, the outlook for the sector looks positive and it remains well supported with AUM’s exceeding their pre-crash highs, partly as a result of the search for yield and partly as a vote of confidence in the sector’s inherent characteristics. However the longerterm structural challenges, where the UK market as a percentage of global dividends paid is shrinking and clients are more comfortable with an international search for yield will provide an overhang and selectors must be aware that current and future talent may seek a broader mandate to compensate for this.

The UK equity income sector is home to many naturally conservative managers but is a far from dull place to invest. The challenge for fund selectors is to match the manager’s priorities to those of the client while remaining cognisant of the rising risk in some areas.

David McFadzean, Head of Investment Solutions, RBC Wealth Management