Fund investors cannot become complacent and should recognise the restrictions and hidden risks associated with collectives, explains Lee Goggin, Co-Founder of findaWEALTHMANAGER.com
It’s only human nature to want to reduce complex things to simplistic formulas and to try to fend off uncertainty with (reductionist) received wisdom. But often doing the “right” thing can lead to the wrong moves. This article summarises the risks and restrictions of investing solely in funds.
Investing only in funds is a powerful example of how a decision which seems savvy on the surface can actually open you up to a range of unforeseen risks. Although we’d all like it to be the case that simply selecting a clutch of solid collectives out of the 8,000 on offer internationally is the “secret sauce”, this is far from being a recipe for guaranteed investment success.
First is the difficulty of picking winning funds. Track records are an unreliable predictor of future success and investors are often frustrated to learn that those which have had a great few years have already passed their prime. With funds holding sometimes 100 positions, their performance is at the mercy of a whole range of risk factors. As recent events have highlighted yet again, whole sectors and markets can take a terrible hit overnight and it may not be as easy as fund investors would like to get their money out quickly.
While investors might feel drawn to their diversification benefits, the sheer number of positions funds can hold is something many fund investors fail to appreciate. When one essentially owns the market then investors could be better off simply buying an inexpensive ETF. Over-diversification can be hugely self-defeating and, if your funds are replicating each other’s positions, you can add concentration risk to the mix too.
Knowing that some funds hold 40% of their portfolio in same four or five positions should inspire investors to look under the bonnet and really understand how underlying assets affect their overall exposures. While they are there, they should also get a firm handle on the costs of how they are investing against returns.
Funds may seem like the most economical option, yet they are often charging multiple layers of fees, including for performance, which could really eat into your net gains. As well as giving your portfolio more transparency, investing in direct equities can actually cut down on costs – and possibly allow you to capture tax-efficiencies more effectively too.
Of course, none of this is to say that funds don’t have a place. They are a great way for early-stage investors to get convenient access to a range of markets and they can play a very useful role in portfolios on an ongoing basis. There are times when buying a fund is the most sensible way to execute a view, but reaching for the nearest – or most popular – collective every time will rarely make your wealth work as hard as it might.
Your profile and investment objectives are highly nuanced and your portfolio should reflect this too. Unfortunately, there are no easy answers and you are likely to require a subtly shifting mixture of funds and direct equities – along with other appropriate asset classes – as your risk and reward parameters evolve.
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