FE portfolios represent independence and outstanding governance

It would be nice if long-term investors could simply set up a portfolio and leave it for 20 years, come back and reap the rewards, but life is not like that.

Responsible money management requires constant monitoring of your clients’ investments to ensure that funds are behaving as they ought to. FE’s advantages in data analytics allow us to do this with maximum efficiency and effectiveness.

The essence of long-term success in building portfolios with superior risk-adjusted returns is blending together assets, funds and strategies which can be shown to behave in different ways in a variety of scenarios and thereby reduce volatility and boost returns.

If funds don’t do what they are expected to do then this all falls apart, and the calculations are no longer correct. This means clients aren’t getting the service they are paying for.

Proper governance requires tracking the behaviour of funds and measuring them up against a range of expectations.

At FE Research we track roughly 90 different metrics constantly for each of the 100 funds on our recommended list to ensure funds are doing what the managers say they are and what investors expect.

This doesn’t mean predicting the future but developing a range of likely behaviours given certain inputs which define normal and expected behaviour. If a fund starts to diverge from this then this is a matter for investigation.

It isn’t always apparent failure that you have to keep an eye on.  A fund’s behaviour may be questionable even if it is doing something that might ordinarily be seen as desirable such as outstripping its index or peers.

A major red flag is if a fund that has a history of holding up well in down-markets and lagging in up-markets starts to perform in line with the index and its peers.

This could mean the managers have changed their strategy, which is the last thing a responsible money manager wants to happen.

If a fund bought for its defensive qualities starts to buy cyclical areas of the market and chase returns then this might give a short-term sugar rush to the portfolio in the form of a spurt in returns but will likely lead to the fund falling harder than expected in a downturn.

As well as making a mockery of the fund selector’s strategy, this is likely to upset the end client more than a few extra percentage points of outperformance will please them.

At FE Research we track roughly 90 different metrics constantly for each of the 100 funds on our recommended list to ensure funds are doing what the managers say they are and what investors expect.

This allows us to spot issues as soon as they occur and get in touch with the managers for an explanation.

The system is designed to meet FCA requirements for advisers’ due diligence, with the intention that the day-to-day legwork of monitoring is taken out of the adviser’s hands.

The metrics are divided into risk, performance, behaviour and structure, and assessed using simple binary scores or more complex probability modelling as appropriate.

Often there is a reasonable explanation for the change in behaviour, which is where the qualitative angle comes in. Quantitatively we can keep track of dozens of issues at the same time and only devote our time and energy to those that require further attention.

The majority of the time when issues are flagged up there is an adequate reason for the change in performance or behaviour. As soon as an issue is raised we run further tests and contact the fund group for an explanation.

One good recent example which shows how detailed our tracking can be is the case of Neptune UK Mid Cap.

Our metrics showed that the fund was moving less in line with its benchmark and sector. However, a more detailed analysis showed that the manager had been building on his long-held sector biases, a strategy which we were aware of and expected to see implemented. As a result, these changes in behaviour were not judged to be concerning.

We observed the opposite happening with the Invesco Perpetual Corporate Bond and Henderson Sterling Bond funds during the same period: both started to behave more in line with their benchmark than usual.

Our analysis showed that this was due to dynamics in the market which were affecting all managers: spreads have been narrowing in recent years and more and more managers argue that the only real value is to be found in certain tranches of bank debt.

It has become harder to generate outperformance against a peer group, while managers are being pushed into similar areas. We judged there was no cause for investors to be concerned about this change in behaviour.

Our analysis and judgement is the essential final step in the process, but the beauty of this approach to governance is its objective nature, and this is where we think it measures up well against FCA requirements.

Funds make it onto the FE Select 100 list, which is used to create our portfolios, thanks to a quantitative process of screening which is entirely independent and measurable. We meet management to confirm the results of the quantitative screening process, but the legwork is done by the numbers and the data.

Our governance process is built on the same principle: the process should be as objective as possible by being based on measurable, quantifiable data. Ultimately this should give the end user the peace of mind of knowing that as soon as their investments start to deviate from what they are expected to do the issue will be investigated and addressed.