Keep it rolling

Investing in actively managed funds is supposed to relieve the problem of stock and asset selection for investors. But investors are still baffled about how to choose the right exchange-traded fund (ETF) or fund manager, and are often disappointed. Performance figures regularly show the difficulty for active managers to simply beat the general market index.

What constitutes a good fund manager? It's a complex question and the answer doesn't necessarily lie in choosing funds that consistently outperform the market.

Former pension fund manager Rick Di Mascio, who runs his own investment evaluation firm, Inalytics, demonstrated that a fund manager's performance depends on luck as much as skill. He observed that, out of 1,188 British funds, only 16 managed top-quartile performance in each of three years he reviewed.

How does an individual pick through the thousands of funds and ETFs to find the above-average portfolio performance?

Rather than search for good fund managers, investors should realise that avoiding poorly performing funds is as important as finding good ones. This means switching out of funds and ETFs that are declining in value or not rising in line with funds with similar asset and risk profiles. It also means investing in funds that are rising in their respective rankings. Rotating from poor to strong performers will help improve returns.

While investors know the folly of holding onto a declining stock for too long, the same applies to being too loyal to a fund in the face of eroding performance. Yet, in both cases, it is difficult to abandon hope.

Hope is rarely a good strategy for investing, and makes no sense given the likelyhood of better options. Continued losses in the form of successively lower valuations will quickly exceed the costs of moving to another fund. If investors cannot bear the high fees of mutual funds, they can consider tracking an index with a low-cost ETF.

Funds require a different approach to investing in stocks. While you are investing in a portfolio of stocks or other assets, you are also betting on a fund manager's ability to adapt his holdings to changing market conditions.

Asian equity markets have been volatile, making it difficult for fund managers and investors to anticipate market direction. During the 2008 financial crisis, many fund managers were unable to change their holdings and switch into cash as fast as the markets were falling.

Few investors realise that investing in a stock implies direct participation in the operating results of one company, but when you invest in a fund, your returns depend on the fund's management style, choice and timing of stock investments.

Fund managers limit the amount of information they release about their investment operations, while plenty of news, data and research can be found about large-cap stocks.

But the principle of momentum, used in trading stocks, can apply equally to funds. Strategies are based on buying or selling stocks on the belief that stock or fund prices tend to follow their own momentum over a period. The discipline is based on the statistical observation that funds that outperform their peers display a characteristic known as persistence of performance.

An effective example of fund and ETF investment rotation can be found in the Sector Momentum Tracker, which is part of the Fidelity Independent Adviser group of newsletters (fidelityadviser.com).

Founder Donald Dion is publisher and chief investment strategist of this service, which features models for aggressive and conservative investors. His newsletters track and rank more than 150 mutual funds run by Fidelity and more than 50 others sold through Fidelity's network.

The fund management giant offers funds covering a huge variety of asset classes. Dion holds that aggressively switching among them can improve portfolio returns.

The Sector Momentum Tracker newsletter follows ETFs and mutual funds, giving buy and sell recommendations based on relative strength indicators developed by researchers. It claimed a 26.6 per cent annualised return in 2007 according to The Hulbert Financial Digest. The model tries to determine those funds whose values are moving upwards and those that are trending downwards.

Rather than trying to understand what the fund managers are thinking, Sector Momentum Tracker attributes its success to quantitative analysis of price movements. Following a hard-nosed read of such data, the fund will rotate investment dollars into the top five performing sectors.

As the momentum of a particular sector matures, the pricing and value of the fund may falter, while other sectors begin to show strength.

Each week they will replace any fund that is no longer in the top five with a fund in the top five that they do not already own. They will take the total proceeds from the sale and invest them evenly in the newly acquired ETFs.

For your own fund investments, you can capture the manager's best and avoid his worst performance by buying into funds with the best recent performances and selling out of funds that are declining in value.

By studying a fund's position in, let's say, the top 10 or 25 in the ranking lists or relative performance tables you find in financial papers (including Money Post), you can determine whether its performance trend is rising or falling relative to its peers. Momentum trading here simply means selling losers and buying winners.

Momentum is best done as an objective, systematic strategy that examines one important aspect of the manager's ability to generate returns - the determination of a period of performance (depending on your investment horizon) for funds sharing a similar asset class and risk characteristics.

Preventing future losses is as vital to your portfolio as making profits. By rotating your fund investments from funds that are losing to those that are accumulating positive momentum, you may be able to improve overall returns.

Peter Guy is a former investment manager with 15 years' experience