How to use Funds in the most effective way

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From various comments on Twitter recently it is pretty clear to me that some thoughts on how to use Funds to best effect would be worthwhile. This should be fairly straightforward to write so I am diving straight in without a plan but I have been mulling it over for a while.
 
If you nip over to the ‘Funds’ page on my Website (it might be on WD2 – I really can’t remember !!), then that has some definitions on it with regards to what the various types of Funds are and it also has an example Portfolio which is based on something I constructed with a Friend a few years ago for her own Investing. Recently she has sold about 80% of this Portfolio because she is moving house and I must get around to confirming with her what she still holds. Anyway, that Portfolio example does give an indication of how you can diversify across Funds if you have a Portfolio that only uses Funds and has no Individual Shares in it. 

​However, please appreciate that this example Portfolio is quite an aggressive one in terms of its Equity exposure and if you plan to go down the Funds only route, and you do not intend to use Hedging techniques to reduce Market Downside Risk, then you perhaps need more ‘safer’ Assets such as Bonds and Cash in your Portfolio.
 
The 2 Basic Approaches
To me the whole Funds thing is fairly black and white in that one of the first decisions any new Investor should make is to decide if they are going to ONLY invest using Funds or if they are going to mix things up a bit by having some Individual Shares and some Funds.
 
The Portfolio Example I mentioned above is very much where the Investor only uses Funds with no Individual Shares and I myself do a mixture but at the moment I am only holding a couple of Funds along with 45 or more Individual Shares. Having said that, I also hold a couple more Funds which are of a more specialist type and I will cover those at the end of the Blog.
 
Arguably this is good sense for all types of Investing, but I think it especially applies with Funds, that you are best to avoid trading them and churning them over and over because they are best used as Buy and Hold Investments. Some people trade with Investment Trusts but I am not convinced this is a particularly clever or successful approach.
 
The ‘Best’ Types of Fund to use
As I mentioned, if you nip over to the ‘Funds’ page it has the various definitions so I won’t reiterate those here. As a basic principle, and a default stance, I would always favour Investment Trusts over the other types. There is certainly a case for using ETFs (Exchange Traded Funds) which are in effect low cost Market Trackers, and they are especially useful in the Shorting variety such as XUKS which is a way to Short the FTSE100 or XSPS which is a way to Short the S&P500.
 
On the whole I would avoid Unit Trusts – this is because of higher Charges and Platform Fees and also because they are not something you can Buy or Sell instantly and for example, if you wish to sell one, then the Price is what you get at 12 Noon (whereas Investment Trusts are constantly repriced in the Market like a Normal Share). I find that irritating.
 
On top of that, for many Unit Trusts you can find Investment Trust ‘equivalents’ which are run in the same sort of way by the same Fund Manager. In such circumstances, it is pretty much always the case that the Investment Trust performs better. The downside with Investment Trusts is that the Price is more volatile and when Markets are moody you can see the Price drop a lot as the Discount to NAV rises or the Premium falls. This does not happen with Unit Trusts which are repriced depending on how the underlying Investments have performed.
 
Investment Trusts can however borrow money because they are actually in a Company Structure and you buy and sell them just like you would any other Share. This can mean more upside if the Fund does well than with the Unit Trust equivalent where it is more limited with whether or not it can borrow and how much. Sometimes you have to buy a Unit Trust because there is not an Investment Trust available – the Mark Slater Growth Fund is like this and if you want the skill of Mark Slater then you can only buy the Unit Trust.
 
People tend to find the concept of Investment Trusts a lot more complicated and this tends to drive them into Unit Trusts when they start out. This tendency is exacerbated by Financial Advisers and Brokers and Magazines and Websites etc. mostly promoting Unit Trusts and barely mentioning Investment Trusts. It is better than it was, but in the old days it was the case that Financial Advisers who were supposedly ‘Independent’ got a Commission Payment for selling particular Unit Trusts – this was most definitely not in the best interest of the Customer !!
 
In all frankness, however experienced you are and whichever basic route to using Funds you want to go down, I recommend you focus on using Investment Trusts and steer clear of Unit Trusts apart from if it is unavoidable. This also means that you can avoid very expensive Platform Fees; because you can use a Normal Share Trading Account for Investment Trusts and ETFs, you can easily find something with a tiny Admin Charge (£20 a year or less) and Transaction Fees for buying and selling are often £5 or £10, that sort of level.
 
If you buy Unit Trusts within a Platform Wrapper then I think they normally charge a Percentage of your Pot and it can mean you are paying high fees like £100 a year or more and it rises as you grow your Pot (to be fair, there is usually an upper limit but it can be very expensive). Tracker Funds are also transacted and held in a similar way on a Funds Platform and this is why ETFs are better which can be bought and sold on a Normal Share Trading Account.
 
I hate to get too complicated in what should be a Blog aimed at fairly new Investors, but I must just point out that ETFs can have some foibles that are worth appreciating. There are 2 basic types – ones that buy the underlying Shares or other Assets that make up the Index they track, or ones that are what is known as ‘Synthetic’ where the ETF does not hold any of the Assets but it works by a ‘Swap’ Agreement between the Issuer of the ETF and a Counterparty. In such a case, the Counterparty will pay to the Issuer the appropriate amounts if the ETF goes up in value or the Issuer will pay to the Counterparty the appropriate amount if it falls in value (it can be done the other way around etc. and there is usually a time period involved).
 
In practice it is probably best to avoid Synthetic ETFs and stick to what are called ‘Physical’ ones because there is always a risk that the Counterparty goes bust or refuses to pay the required Amounts etc. With a Physical ETF you avoid that additional risk, although sometimes it is unavoidable if you want exposure to a particular Asset Index.
 
Despite all my protestations about keeping this simple, I will also mention the concept of ‘Optimised’ ETFs where the ETF Provider does not buy all of the Assets in the Underlying Index but buys the ones that really make a difference and move the Market. For example, an Optimised ETF that tracks the FTSE100 might hold only 60 of the Shares because the other 40 are relatively small weightings in the Index and don’t move it much. This optimisation means that the ETF tends to be lower cost, but the downside is that it is likely to have higher ‘Tracking Error’ which means in this case that if the FTSE100 rises say 15% over a period of time, then the Tracking Error leads the ETF to only gain 14.6% or something.
 
Using Funds without Individual Shares
It is an entirely reasonable, and perhaps even sensible, decision to go down the route of just holding Funds but along with upsides, it also has downsides. The benefits are that it is very much something that is best done in a ‘hands-off’ manner and immense effort should be put into building the Portfolio in the first place and then you need to have regular reviews where you look at the various weightings between Asset types and the Funds you hold and you need to consider rebalancing and suchlike. I would suggest at least a 3 monthly review but if you do it too often then it is human nature to tinker and to end up selling things you shouldn’t and buying stuff you shouldn’t !!
 
When you get going with your ‘Funds only’ Portfolio I suggest you put a lot of thought into the various Weightings between the various Asset types and it is worth creating some sort of ‘Rules’ document which you can regularly refer to when you do your 3 month (or whatever time period) reviews. This initial determination of Weightings and Rules is not something to rush and you need to also periodically review these Rules but make sure you do not do changes just for the sake of it. If you go to the ‘Related Blogs’ section at the very end of this blog, then you should find an example of a Rules document I use myself.
 
Perhaps a review of the Weightings and Rules once a year is appropriate but your default stance should be to do nothing unless you have an extremely good reason. Any changes you make should also be small and incremental rather than fundamental changes where you rip everything up and start again; unless of course you really have made a pig’s ear when you created the initial Weightings and Rules in the first place (that would be because you did not spend enough time on it and you did not give it enough consideration and if you can it would be wise to consult the inputs of clever people you know in the world of investing).
 
To my view, choosing to just hold Funds is really for people who don’t have the time or the inclination to get involved in messing about with Individual Shares. The downside of this is that you might get lower Returns but in reality the buying and selling of Individual Shares is quite difficult and many people would probably do better just by buying a load of Funds in a diversified Portfolio and leaving them to do their thing. At least it is likely that your Returns will track the Markets and that in itself would beat most Private Investors and Traders who muck about with Individual Stocks.
 
Another big risk with holding a Portfolio of Funds is that you are not protected from Market Downside unless you hold such a mix of different Assets Classes that you do have protection. Historically it has been recommended by Financial Advisers etc. that you should perhaps hold something like 60% of your Portfolio in higher risk Equities and the other 40% in lower risk stuff like Bonds especially (that would be for an ‘Adventurous’ Investor and a ‘Cautious’ Investor might need just 30% in Stocks). However, that tends to work to varying degrees when we get a big Market Sell-off and it is one of those things where you don’t know if the balance of your Portfolio will work well until the Sell-off actually happens – and at that point you find out whether or not you got it about right.
 
You also then get the problem that if your Portfolio did not work particularly well in a big Market Sell-off, that you adjust it for the next time, and when that comes it doesn’t work as you wanted either !! It is a fact of anything to do with Investing that you will never get 100% perfection and in all aspects you just need to be ‘roughly right’ and just avoid being ‘utterly and completely wrong’ if you can help it !!
 
And of course the price you pay for having this Diversity between Equities and Bonds in your Portfolio is that you will get lower Returns than if you just held Equities when times are good. It really is all about Risk and Reward and balancing those in a way that you are comfortable with and which should just about achieve your long-term Financial Goals.
 
As an indication, if you go down the ‘Funds only’ route I would guess you need to be realistically targeting Returns of about 6% to 8% a year on average. However, as I hinted at just above, if you play it Risk-averse and go for a lot of safety with heavy weightings in Bonds and Cash etc., then you might only get 5% to 6% a year. If you stick your neck out and go in very heavily on Stocks and high risk themes, then maybe you can get up to 10% but it will be scary in the bad times.
 
Theoretically you might be able to remove a lot of Market Downside Risk by use of Hedging techniques such as by purchasing Put Options on Major Indexes – but this is a very sophisticated strategy and not something I would recommend for inexperienced Investors. I do however know a few people who do this sort of thing and it does seem quite a sensible method. I myself Hedge using Index Short Spreadbets but this is quite sophisticated for Newbie Investors and not easy to do.
 
The other drawback of Funds Only Investing is that it is really ‘kin boring.
 
Using Funds along with Individual Shares
This is more along the lines of what I do myself. In general I like to buy Individual Shares in Companies because it is something I enjoy doing as I like the challenge of investigating different businesses and trying to figure out which ones are likely to do well in the future and whether or not their Shares are undervalued etc. (and let’s face it, if I wasn’t doing this I would be out causing trouble in the streets). I also think it is possible to make superior Returns to those that can be made just from holding Funds but the gains in truth are probably only marginal and a bad year or two (which is far too easily possible) can soon knock you off course.
 
If you just hold Funds you are much less likely to get these idiosyncratic years where your Portfolio just sort of ‘goes wrong’ perhaps because a few Companies you hold Stocks in go badly. At least with Funds you will get close to the average Market Return whatever happens (but you are exposed to Market Risk and without Hedging you just have to suffer).
 
Of course, to get superior Returns on a Portfolio of Individual Shares then you can hold less of them and increase your overall Volatility Risk – this can work well in the good times but be very terrifying when the Markets take a severe dive. Over a period of years you will figure out what sort of Investor you are and how comfortable you are with Risk but you can only really know once you have experienced a proper heavy Market Sell-off and you really know what fear is. I suspect many Private Investors who have only been involved in the Markets for a few years, found the recent Sell-off due to the Coronavirus Crisis rather scary and are now considering how to lower their Risk as they found the sleepless nights rather irritating.
 
I quite like having a few Funds in amongst my Stocks because as well as enabling me to play some pretty obvious ‘Big Themes’, they also add to the Diversification of my Portfolios and that cannot be a bad thing as far as I am concerned (I like my Risk levels nice and low and controlled and I also like a ‘Do Nothing’ Portfolio so I can be in the Pub – if it is ever open !!).
 
I am not sure what the optimum number of Funds would be for me, but at the time of writing this I hold Polar Capital Technology PCT and Worldwide Healthcare Trust WWH to play the mega-Themes of Tech and Health, which are both ones that obviously are good to be in as mankind gets more embedded with Technology and develops ever more sophisticated ways of keeping us alive and of course the population gets ever older and more in need of a wide variety of treatments.
 
With my Income Portfolio I currently hold 12 Stocks and I intend to slip up to 15 Stocks over time and as things stand, I do not envisage going much over this number. With a limit of 15, there might be a case for 1 or 2 Funds (most likely Investment Trusts) but I need to consider the Market Downside Risk although I do have the advantage that I am happy to Hedge using Index Short Spreadbets if we do get trouble. I quite like the idea of at least one Fund in my Income Portfolio because it would help to increase Diversification and I am a big fan of this – particularly with a ‘do nothing’ Portfolio like my Income Portfolio is designed to be.
 
With my main Portfolio, which is the WD40, by definition I obviously have a maximum of 40 stocks and within this constraint, I guess I could go up to around 5 or so Funds but at the moment I just have the 2 I mentioned. I don’t really need to add Funds for Diversification in this case and I have no shortage of Individual Company Stocks I would like to hold (see my ‘Little Black Book’ on WD2 for a list of potentially interesting Stocks).
 
Of course we all need to weigh things up and consider our own desired Risk and Activity levels etc., but for Newer Investors it might be worthwhile holding a few General Funds in the form of Investment Trusts if possible, to diversify away the Risk that you might underperform on the part of your Portfolio that you manage yourself and use Individual Company Shares for. In effect you would be calling on the skills of an experienced Fund Manager to make up for any possible deficiencies in your own Management ability. If you go down this route, then perhaps after a few years as your confidence rises and your Returns justify the change, you could reduce the number of Funds you hold so that you take more of the Management task upon yourself.
 
Some twists on the Funds themes
I am actually adding this final section very much at the last minute before I publish because I realised earlier today that it was a bit of a glaring omission. In essence there are a few other types of Funds that are sort of a bit different (this might not be all of them but it should cover the common ones at a high level):

• Real Estate Investment Trusts REITs – these are a special type of Investment Trust that, as the name suggests, invests directly in Property which can be Commercial stuff like Factories, Offices, Sheds, Warehouses, Student Accommodation, Health Centres etc. etc. or can be Residential Property like Flats and Bungalows etc. for Housing Associations. There are some special Tax reductions for REIT status which requires Earnings to be mostly paid out as Dividends I think. I often invest in REITS and at the moment hold Primary Health Properties PHP and Empiric Student Property ESP.

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• Infrastructure Funds – these invest in things like Bridges, Roads, Tunnels, Electricity Generation, Renewable Energy and many other variations. They are often PFI or PPP structures (Private Finance Initiative and Private Public Partnerships) and tend to have reliable and predictable Cash Flows from things like Tolls or regular Government Payments etc. I have held these in the past but I don’t think I have any now and things like The Renewables Infrastructure Fund TRIG, John Laing Environmental JLEN, HICL Infrastructure HICL and SDCL Energy Efficiency Fund SEIT are all examples and they are many and varied and tend to have good Dividend Yields.

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• Private Equity Funds – This is not something I tend to get involved in and I think they can be Unit Trust or Investment Trust structures – but after the fiasco of the Neil Woodford Funds collapsing, I would suggest you avoid Unit Trusts and stick to Investment Trusts if you do decide to go down this route. Private Equity stuff is very illiquid as it is not listed on a Stock Market and this makes it risky and best held in an Investment Trust structure. There are also some twists on this with Investment Trust companies like Crystal Amber CRS, Volvere VLE and Gresham House GHE which are almost a hybrid of several Fund types where they invest in a few Companies that might be listed on AIM or occasionally Unlisted. Some of these are actually very good but you need to know a lot about the Managers and in particular their Track Record.

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• Venture Capital Trusts VCTs – these invest in early stage and start-up Businesses and as such are very high risk and you need to understand what you are doing. I don’t so I keep away from them !! I have included this here because there are some Investment Trusts that do a similar thing that are Listed on the Stock Market – for example Draper Esprit GROW is in this vein and I think Syncona SYNC is a bit like this. I don’t find these things particularly something that appeals to me and they seem quite unpredictable and hard to value.

 
OK, that’s it for this one. I hope it helps Readers clarify their thinking on how to use Funds for best advantage and as ever, the golden rule is to keep it simple and think carefully before rushing into anything.
 
Cheers, WD.
 
 
Related Blog
This one should help clarify the different types of Downside Risk:
 
https://wheeliedealer.weebly.com/educational-blogs/thinking-about-downside-risk
 
Here is an example of a Rules document I have for myself:
 
https://wheeliedealer.weebly.com/educational-blogs/yearly-trading-rules-parameters-template