Why are Britain's biggest funds sinking?

2008 is not proving good for investors in the UK’s biggest and most popular funds. Some of the most well-known names in the game have been caught out by the credit crunch and have posted dismal performances.

Figures from Morningstar, the data firm, show that the average UK equity income fund - the bread and butter of many investors’ portfolios - was down by about 13% over the past 12 months to May 2008. Some of the big-name funds, including several from New Star Asset Management, are even lagging well behind this.

Toby Thompson’s Higher Income fund is down nearly 27%, for example. Meanwhile, George Luckcraft’s Axa Framlington Equity Income fund is down close to 24% over the 12 months to 1 May, and Anthony Nutt’s Jupiter Income Trust has dropped nearly 19% over the same 12-month period.

Even the highly acclaimed Neil Woodford has found it tough going - his huge Invesco Perpetual Income and High Income funds are down by about 12%.

High-fliers of the UK All Companies category have also struggled: New Star’s UK Growth fund, managed by Stephen Whittaker, is down 26% over the past year to May 2008, while Patrick Evershed’s New Star Select Opportunities is down close to 24%, Morningstar figures show. By comparison, the sector is only down by around 9%.

What’s gone wrong?

Philip Pearson, partner at Southampton-based IFA firm P&P Invest, says most of the leading equity income funds have been severely affected by the credit crunch. "This is due to their investment in financial stocks and the significant reduction in the value of banking shares over the past year," he explains.

Pearson says it is quite normal for equity income funds to have a weighting of 20-30% in financial stocks, as banks have provided a high level of dividend income in the past, which has risen over the years as share prices increased.

"Unfortunately, this weighting towards financials has been to each fund’s detriment as the prices of banking shares have collapsed over the past 12 months," he adds.

Felicity Smith, senior fund manager at Bedlam Asset Management, also believes the performance of financial stocks has taken its toll on these funds.

"The big hit has been the banking sector and we’re still very, very negative there," she says. "The problem is that the large funds tend to measure themselves against the index, and a big chunk of the index in Europe, including in the UK, is banks. People don’t want to make too big a bet against that.

"Funds like ourselves don’t have that problem because we’re measuring ourselves against cash. Our view is that it’s too early to call the bottom for the banks, so we would still steer clear."

Alan Adam, financial consultant at Linlithgow-based Alan Steel Asset Management, says Neil Woodford is something of an exception to this as his fund doesn’t hold banking stocks. "But he has been hit with underperforming utilities and pharmaceutical stocks," Adam adds.

Woodford himself describes the recent performance of his funds as "disappointing". But it’s not his style to worry about short-term market wobbles, preferring instead to take a three-to-five year view. "I’m confident in the portfolio and in the ability of the fund to deliver good, absolute and relative performance over that period," he explains.

At Jupiter, Tony Nutt’s decision to take profits in the mining sector last year meant his Income Trust was left behind. "We chose to take substantial profits in 2007 as I felt share prices were looking expensive at a time when there were indications that miners faced less easy operating conditions," he says.

Contrary to his expectations, however, the sector remained one of the strongest performers in the index during the early part of 2008.

But, although that decision did cost Nutt performance, if his convictions prove correct in the long-term, he could yet put the smile back on his investors’ faces.

How should you react?

The experts suggest that if your investment objectives and risk profile are the same as when you first invested in the fund, then you should stay put, despite short-term underperformance.

"As banks declare their debts and write off their liabilities, the value of shares will recover," Philip Pearson says. "This will feed through to the leading equity income funds, resulting in a recovery in performance over the next few years."

He believes that switching away from these core holdings now will only crystallise the drop in value of each fund, leaving investors with a capital loss.

James Davies, investment research manager at IFA and broker Chartwell Group, also thinks that most investors in the big classic UK funds would be best served by sitting tight during the current volatility.

"It’s always worth revisiting why you originally took a fund out. But if your investment objectives are the same as they were, stick with them. However, there are a couple of funds out there that I don’t have much faith in at the moment. I would be concerned if I was in the New Star Higher Income as it hasn’t done particularly well over the past year," he adds.

On a more positive note, Davies says that many UK fund managers are likely to be "licking their lips" right now because they can pick up good companies for a fraction of the price they were last year.

"Perhaps you might not want to go into banks or house-builders right now, but if you’ve got a three-to-five year horizon - which a lot of these fund managers have - you might not be too worried if you’ve taken a bit of a blow over the last few months, especially if you’ve been able to purchase companies you like at a knockdown price," he says.

Alan Steel Asset Management is recommending clients in funds such as Woodford’s and Nutt’s to stay put, but is moving clients out of funds such as Luckcraft’s equity income fund. Alan Adam also has concerns about the Evershed fund.

"Luckcraft has been underperforming for far too long, even when you take into account his exposure to banks and small Aim stocks. As a company, we’ve known him for a long time - he was a good fund manager at ABN AMRO - but we feel he’s lost his way of late," Adam says. However, he describes Nutt as a top fund manager and believes he will "come good".

Worldwide Financial Planning IFA Nick McBreen believes the volatile times are likely to continue. "But that’s not a reason to doubt the intrinsic qualities of funds like Woodford’s. The fundamentals of good fund selection should apply equally well to stormy times as when the sun’s out," he says.

Brian Dennehy, managing director of Kent-based IFA firm Dennehy Weller, suggests that, whether you are invested in the big-name funds or not, you need to stay vigilant.

While ordinarily an investor might sell a fund like New Star UK Growth based on its relative performance, he believes that with current market conditions it’s also important to look at who is outperforming as funds start to recover.

"On that basis, right now I would be a buyer of the New Star fund, although ideally I’d like to wait another month or two," he says. This tallies with his expectation that the next stockmarket upswing will see growth funds faring better than equity income.

However, Nick McBreen takes a similar view to managers like Woodford, and says he pays no attention to 12-month and three-year fund performance levels, suggesting instead that investors should focus on a fund’s five-year track record. "Don’t worry about the short-term fluctuations, because if you do, you’ll never sleep at night," he advises.

What about new investors?

Philip Pearson believes the current market volatility is likely to continue for some time, so new investors should choose funds best suited to these conditions.

"Normally, funds that take a contrarian perspective are ideal in identifying value just when most investors are fleeing to safer areas," he says.

Pearson likes the M&G Recovery fund, managed by Thomas Dobell. "His investment strategy is ideal for current market conditions and should reward anyone prepared to commit for a minimum period of three years, providing substantially higher returns than that offered by cash over this period," he says.

James Davies, meanwhile, continues to favour Woodford’s High Income fund and Nutt’s Income Trust, saying that both Woodford and Nutt are typically quite bearish and have strong performance histories.

"Both of them have a track record - and that’s important when looking at fund management over different time periods," he adds.

In the UK Equity Income sector, McBreen also favours Woodford’s fund, along with Artemis Income and the F&C Stewardship Income funds, among others. In the All Companies sector, he looks to the Rensburg UK Select Growth, Saracen Growth Alpha and the New Star UK Alpha funds.

However, McBreen warns that such funds are only suitable for the medium-risk investors and that those looking for lower risk should consider something like F&C’s Maximum Income bond, JP Morgan’s Global ex-UK fund or Invesco Perpetual’s Monthly Income Plus.

Alan Adam says he has been encouraging clients whom he has moved out of some of the big funds to gain more exposure overseas, although that, of course, involves taking more of a risk.

"We actually think there’s better value going to overseas markets at present," he says. He suggests the M&G Global Basics, Neptune Global Alpha and the CF Richmond Core funds.

Felicity Smith agrees. She believes that continental Europe will not see the same level of economic slowdown as the UK, because consumer indebtedness is much lower, while consumer spending has already been at low levels for some time. "Generally speaking, for a sterling-based investor, if you can invest abroad, now is the time to do it," she says.

Meanwhile, McBreen stresses the importance of holding your funds in fund supermarkets, so if you need to switch funds you can do it at no charge. Otherwise, if you switch in a falling market, you could also be hit by a 5% moving fee.

It’s always worth taking the time to review your portfolio, but while performance may currently be disconcerting, if you’re invested in some of the old-faithful UK funds, it’s not necessarily the time for a mass exodus just yet.

As McBreen says: "If people are going to be influenced by short-term events, then it really raises the whole question about their rationale for being invested in the first place."

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