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Pick ‘n’ mix: how we select funds

There are over 7,000 investment funds we can choose from when building a portfolio.

From this vast array, we need to eliminate 99.6% to get to the 26 funds which currently make up a balanced portfolio. This means we need a robust and repeatable process.

When considering buying a fund the first decision is whether to go for an actively managed fund or a passive index tracker. The former are actively managed by an individual manager or team of managers, whereas the latter mirror the components of a market index. We will only select an active manager if they have a proven record of outperforming the index after costs on a repeatable, risk adjusted basis. If not we will go for a passive fund. Either way, costs are extremely important.

Whether to go active or passive partly depends on which sector you are looking at. For example, in US equities we find that very few active funds consistently beat the market, favouring a passive approach. Meanwhile, in the UK smaller companies sector there is strong evidence that a good active fund can outperform.

We screen each fund sector regularly using our own proprietary screening tool. This takes data from Financial Express (the industry-leading data, software and analysis company) and runs an array of calculations. In total, the system looks at 11 different factors and gives each fund a score. The factors we look at are:

  • Consistency of performance
  • Consistency of alpha – a measure which shows whether stock selection has added or detracted value
  • Volatility
  • Cumulative performance
  • Maximum drawdown – what is the worst loss you could have made buying this fund?
  • Maximum gain – what is the largest possible gain the fund has made?
  • Upside capture – when the market goes up, how much of this does the fund tend to capture?
  • Downside capture – how much does the fund go down when the market goes down?
  • Participation ratio – the ratio of upside to downside capture
  • Sharpe ratio – how much return does the fund achieve for each unit of risk?
  • Activity score – interprets how ‘active’ the fund manager is.


The system gives each fund an overall score, however we can also filter any of the categories depending on what type of fund we’re looking for. This process allows us to whittle a sector down to three or four potential candidates with the type of behaviour we require.

The next stage is due diligence. We ask the fund manager to complete a detailed questionnaire about their process as well as regulation and risk controls.

After all this quantitative analysis the next stage is much more human. If a fund passes the first two tests we then meet the manager to get more of an in-depth idea of how they manage the fund. We like fund managers who are calm, relaxed and knowledgeable and have a strong, repeatable and easy to understand process.

If a fund is included in a portfolio, it is then constantly monitored and formally reviewed each quarter.

It is a fund’s behaviour that is crucial. Funds will never outperform in all market conditions. That is okay, but if a fund underperforms at a time we would have expected that style to do well, that is a concern. Similarly, if a fund does better than expected in a particular market condition, that raises a red flag as it could indicate the manager is doing something different to what we had been led to expect.

This process has proven results. Each month we monitor the performance of the funds we hold over various time periods, including the period since we bought it. Funds are scored as ‘amber’ if they are within 10% of their benchmark, ‘green’ if they are more than 10% ahead, and ‘blue’ if they are more than 25% ahead.

At the end of July 2016, 91% of funds held in portfolios are amber or better over the period since they were purchased.

However, whilst this is a pleasing ratio, as George Soros once said: “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

Happily, that is very much the case and 65% of funds have beaten their sector by at least 25% since purchase.

Whilst we still believe that asset allocation is the key driver of long-term returns, fund selection can still add significant value.