To keep assets agile in a turbulent market, it is best to give your fund manager the flexibility to make quick adjustments.
Fiscal View: Flexible funds give assets room to manoeuvre
When you buy a UK equity fund, you will not be surprised to learn that the fund manager invests your money in the UK stock market.
If it is a fund that specialises in blue-chip companies, then he will buy shares in the 100 companies that comprise the FTSE100 index. And if it is a fund that specialises in mid-sized companies, he will usually buy shares in companies that make up the FTSE250 index.
This is all he can do; he is not allowed to buy anything else.
If, for instance, the fund manger believes the UK stock market is going to fall, he cannot sell off all his share holdings. The best he can do is to sell off shares up to the cash limit that is allowed for a UK-regulated fund. This is 10 per cent, as specified by the country's Financial Services Authority.
So if the UK stock market is going to fall and every man and his dog knows about it, you, as the investor, can't expect the fund manager to save you. His hands are tied. With a conventional "long-only" fund, where the manager buys and holds stocks, there is nothing he can do to withstand the fall except to hold as much cash as he is allowed and to select stocks that might weather the storm.
If this frightens you, and it should, then you need to reduce the risk. One way of doing this is to buy a fund that gives the manager the freedom to use other investment strategies.
If he is allowed to "go short", for example, then he can make money as prices fall. In this strategy, he sells a stock that he does not own at the current market price. He then borrows the stock from an institution that owns loads of the stuff, such as an insurance company, and pays a small rental premium for this service.
With this borrowed stock, he is able to demonstrate that he can deliver on the contract. When markets fall, he buys the stock, closes the deal with his customer and returns the borrowed stock to the insurance company. Thus, he has made money on a falling market.
It may sound complex, but all the manager is doing is using the old adage of buying at a low price and selling at high one. He simply does it in a different order. Funds that combine these strategies are referred to as long/short funds. The manager goes "long" on the shares that he thinks will do well if markets rise and goes "short" on those that he thinks will do badly if markets fall.
This is a typical hedging strategy that is designed to limit your "downside losses" by sacrificing some of your "upside gain".
In the long/short strategy, the underlying investment asset remains the same. Whether the manager goes long or short, he is still buying or selling UK equities and the potential for him to make money and reduce risk will be limited by the performance of that asset class.
If there is no trend in market prices, either up or down, then the manager will not be able to make money with either long or short strategies. For reasons that have always baffled me, when this happens, hedge-fund managers say markets are moving sideways - when, in fact, they are not moving at all.
Another way to reduce the possible effect of a fall in equity prices is to give the manager freedom to select other asset classes.
This requires a different kind of fund. You could, for example, buy a global equity fund where the manager buys equities (or equity indices) throughout the world.
Theoretically, if the UK equity market is predicted to fall, then he could sell UK shares and buy US ones instead. This will add more diversification to your investment, but is not a perfect solution. Firstly, the manager is not allowed to stray too far from his benchmark allocations, otherwise it would not be a true "global equity" fund.
Secondly, global equity funds introduce a new kind of risk to the UK investor - currency risk.
And thirdly, equity markets throughout the world, generally, exhibit a great deal of "correlation", especially to the US market. During the dotcom crisis, for instance, when the US markets fell dramatically in 2000 and 2001, so did equity markets throughout the world. Diversification by country gives a degree of protection, but when the nasty stuff hits the fan, equities all go the same way.
But during this crisis, in contrast, cash, bonds, property and hedge funds performed much better.
So what you need is a manager who has the authority to change your asset mix to suit your attitude to risk and to take advantage of these market opportunities.
This type of fund is called a multi-asset fund and, if it features different managers for each asset class, it is called a multi-asset, multi-manager fund.
There are number of these types of fund on the market and I have reported before, in this column, on the excellent Harmony range offered by RMB Asset Management, which is based in Guernsey.
But it is pleasing to be able to tell you about the range now offered by Emirates NBD Asset Management. Emirates NBD offers three multi-asset funds: Active Managed, Balanced Managed and Conservative Managed, all domiciled in Jersey.
As their names suggest, each fund is associated with a different degree of risk and this is reflected in the asset allocation - the more risky the fund, the more exposure to equities.
The Active Managed Fund, for example, has 61.5 per cent exposure to equities, whereas the Conservative Fund has none at all.
Bill Davey is a financial adviser at Mondial-Dubai. If you have any questions about his column, e-mail him at firstname.lastname@example.org