From Special Report: Investment Adviser Mid-Year Monitor
On the edge of closure
For a second year running, the number of IMA-listed funds in danger of closure or merging has increased
The number of IMA-listed funds potentially in danger of being closed or merged with a sister fund has increased for the second year running, from 58 in 2011 to 67, Investment Adviser research has discovered.
Of these 67 vehicles, identified using a metric incorporating Morningstar data, 40 of them appeared consistently in the third or fourth quartile of their sectors over one, three and five years, with the remaining funds all third or fourth quartile over five years.
Ben Seager-Scott, senior analyst at Bestinvest, says: “The number of red flag funds has increased this year, and this may partly be a function of undulating markets. Often such broad market movements are fairly indiscriminate, causing benchmark constituents to move largely together – for some unconstrained stockpickers who have high active positions versus the benchmark this could act against them and could be a reason we see more funds flagged this time around.”
In fact, the 38.86 per cent rise in the number of “red flag funds” is not surprising given the volatility in the markets in the second half of 2011, as Meera Patel, senior analyst at Hargreaves Lansdown, explains: “Even though this year started off well, the optimism was soon cut short as renewed worries over Europe has turned markets jittery. There has been an enormous amount of sector rotation from defensives to cyclicals and if a fund is on the wrong side of the defensive/cyclical play, it has been easy for funds to underperform.”
The 2012 list of ‘red flag funds’, which manage an average of £6.18m each, includes nine from the UK All Companies sector. However, the IMA’s three former Managed sectors have the most flagged funds combined, with seven in Mixed Investment 20-60 per cent Shares and four each in the Mixed Investment 40-85 per cent shares and five in the Flexible Investment sectors.
Closures or mergers so far
Of last year’s predictions, 30 funds have carried over into 2012’s list and 18 funds have since closed or merged, equivalent to 10.44 per cent, while already this year’s metric has identified two funds that are earmarked for closure or merger.
In April, Franklin Templeton announced an overhaul of its UK-based fund range including the closure of the £5.3m Franklin Global Reit (or real estate investment trust) fund and the merger of the £5.29m Templeton UK Equity fund into the £31m Franklin UK Managers’ Focus fund.
Meanwhile Scottish Widows Investment Partnership (Swip) is in the process of repositioning its equities business, including some fund closures. The company has three funds in the list: the Absolute Return Macro, Japanese Equity and UK Real Estate funds, which rolled over from the 2011 list.
A company spokesperson says: “Swip is beginning the process of transitioning a number of funds to its new equities strategy. This process will take some months and will result in the closure of a number of smaller regional equity funds that no longer fit with the revised investment strategy, in addition to some funds that due to their small size are no longer economically viable for Swip to manage.”
Ms Patel says she is in favour of such moves. “For a long time I’ve felt there are too many failing funds in the market and more should be done to consolidate them. For funds that are small in size, I feel more groups should be willing to merger or close these funds. Small funds are costly to run and it’s the investor that pays for these high charges in most cases, so it is not in their interests to keep these funds open, unless the groups can guarantee the size will grow and the charges fall.”
Mr Seager-Scott agrees, noting that high costs can drag on performance – the average total expense ratio for red flag funds is 1.94 per cent and the highest is 4.36 per cent.
“At these levels, it may not be viable for groups to support these funds, and this is likely the driver behind recent events which have seen groups close or merge vehicles and has led some groups running weak funds to look to internal restructuring as a possible solution,” he adds.
Red flags still standing
Of the remaining providers of “red flag funds”, EFA and Marlborough each have seven in the total list, with EFA having four in the list of 40 consistent underperformers and Marlborough having two, the Marlborough European Trust and the Marlborough Ethical fund. The EFA funds flagged up include products run by Julius Baer International, Goldman Sachs International and Morgan Stanley International and OPM Fund Management
Nicholas Cooling, deputy chairman of Marlborough Fund Managers, says the majority of the Marlborough funds identified have shown a significant improvement in performance over one year, including the Marlborough Global fund, which has been heavily modified.
He adds: “Of the funds, three – Marlborough Cash Trust, Marlborough European Trust and Marlborough North American Trust – were only added to our fund range in September 2010 following the acquisition of SLFC United Managers (UK).
“Our new managers have had little more than 18 months to replace holdings and turn around performance but in that time all the funds have shown significant improvement.
“Two funds serve very specific purposes. The Marlborough Extra Income fund is managed specifically as a ‘revved up’ cash-plus vehicle for clients. The Marlborough Ethical fund is managed using strict socially responsible investing criteria laid down by the Joseph Rowntree Charitable Trust and the Quaker church. While this approach is valued highly by some investors it does mean comparison with other UK All Companies funds without an ethical mandate is not entirely fair.”
Paul Wilcox, chairman of the Way Group, which is the authorised corporate director for the EFA funds and Elite funds with external managers, argues funds perform differently in different phases of the market and there is plenty of anecdotal evidence that funds which are lower down the tables will often be above the median in future years.
“Of course it is more difficult to build funds which appear to be less competitive from a performance perspective and so they may remain modest in size for longer than one would wish – but this suggests that everyone is unhappy about sub-£10m funds, and that is not true. There are many successful funds under £10m,” he says.
“Way supports new and up and coming fund managers and often they are delivering returns which are specifically geared to their investors’ requirements rather than aimed at performing against IMA benchmarks against which they happen to be placed. We review all of our funds on a regular basis and while size is an issue at extremely low levels, such considerations are not linked to an arbitrary and relatively healthy £10m.”
Ben Willis, investment manager and head of research at Whitechurch Securities, agrees that some funds are small for a reason, especially if they are being managed by someone new.
“When equities are in favour, it is natural that investors will look to experienced managers with proven track records and, in most cases, this means plumping for an established fund that already has significant assets under management.
“It takes quite a leap of faith to start going off the beaten track and investing in a small fund being run by a manager who may be a star in the future but who is only just embarking on a career path.”
But while some funds are small in order to fill a particular niche or support new managers, others seem to have a less solid argument for remaining open.
Mr Seager-Scott says: “In the investment industry, it can often be as important to know which funds are likely to underperform as it is to find finds that will outperform. This is a great report that, along with others in the industry, raises a warning signal on funds that don’t seem to have been pulling their weight.
“However, it’s also important to note this doesn’t mean they should automatically be sold – rather investors should be minded to review the holding and investigate further.”
Mr Seager-Scott argues a red flag fund’s particular style could simply be out of favour, and that investors should look at performance over different timeframes as a bad period this year can affect three and five-year data. However, he says that if funds disappoint consistently, groups should review whether they should be keeping them open.
“For example, the HSBC Common Fund for Growth had a weak April, which sees it come in third quartile over five years – but if you measured it a month earlier at the end of March it becomes second quartile,” he explains.
“That said, a lot of these funds are likely to be past their prime and most probably do need to take a cold hard look at themselves in the mirror, particularly those that are routinely disappointing. One fund that has performed particularly badly is the Melchior UK Opportunities fund, which got severely carried out during the financial crisis and never really recouped its losses. At its peak this fund was more than £120m but now has shrunk to £4.9m.
“The recent turmoil has really taken its toll on a lot of funds, and too often managers have been hurt by being exposed to assets highly sensitive to market cycles but then missed out on the bounce by moving defensively at the wrong time – buying at the top and selling at the bottom.”
But while further consolidation in the industry is expected and in some cases needed, statistics from the IMA show that in 2011 there were 114 fund launches and only 43 closures or mergers, the smallest figure for five years.
Mr Willis notes: “Small funds will continue to operate as long as there is investor apathy and so the asset base remains relatively stable, with no sustained or significant outflows.
“It is mercenary, but as long as the fund can continue to be operational and the fund management group can cover the expense of running the fund and still make money from charges, then they will still be a viable proposition.
“However, with the RDR coming this has had a knock-on effect for underperforming funds and made fund management groups rationalise their fund ranges, resulting in cutting off some dead wood.”
Nyree Stewart is deputy features editor at Investment Adviser