How to measure a fund

Wednesday, Apr 16 2014 by

Buying something, whether it’s a car a carpet or a company, is a tricky process. It involves quantifying the asset being purchased, such as number of seats, size or profits, and then forming a judgement on the value of those properties. It may include a premium for branding or possibly a discount for damaged goods. In the end the buyer takes a view on the asset to be purchased and agrees a value for the transaction based on the most appropriate measure

One area though where it is hard to find a relevant measure is in collective investment vehicles. The back pages of financial magazines are full of endless tables of past performance. We all know, and the FCA takes great care to keep reminding us, that past performance is no guide to future returns.

The reason is simple.

Investment performance is a complex blend of returns of the asset class, security selection, leverage, use of financial instruments and cost. It might be interesting to know that Ocado has been the best performing share in the UK market over the last twelve months but not everyone wants to invest a significant part of their portfolio into a business that has never made any money and may never do. Funds that were lucky enough to have a holding in it did well despite its high valuation. Conversely, funds that did not want to pay too much for an unproven business suffered.

Many investors are now attracted by the apparent simplicity and low costs of exchange traded funds (ETFs) that claim to replicate the returns of a designated index. However, digging out the exact composition of their portfolios can be time consuming and surprising. Holding a futures contract on a constituent of an index is not the same as holding the security itself.

History tells us that overpaying for any asset is more likely than not to result in weaker returns in future years. While that can be relatively easy to make a judgement on value for a single stock like Ocado it is more difficult for a fund that may have over hundreds of shares in it.

Collective investments maybe like elephants. Everyone knows what they are even if they might struggle to describe them. Trying to measure them is even worse.

There is one measure though that is quoted for most funds that can be used to make a simple and quick comparison.

Almost all funds quote a figure for yield, the dividends paid out divided by the fund price. During bull markets, such as we have seen since interest rates were slashed five years ago, dividend paying stocks have been shunned in favour of smaller stocks focussed on growth. Since dividends can be regarded as smoothed earnings per share figure that glide over the lumps and bumps of exceptional items they provide a good guide to underlying earnings. On top of that they provide tangible evidence that the company can generate surplus cash that can be returned to the investor.

So it seems a reasonable proposition that a collection of similar stocks in a fund can be measured in aggregate by their yield. If one group of stocks (fund A) has a higher yield than another group (fund B) than it is reasonable assumption that Fund A has, overall, a lower valuation than fund B.

Some will argue that this is not a fair measure because it ignores capital returns, either from the securities or derivatives on them. There is some validity to that argument but it reminds us that derivatives generally provide returns as capital, not dividends, and not all growth stocks deliver on their aspirations.

Others may say that a high yield is unsustainable and it merely presages a dividend cut. But a large fund that holds the bulk of the market will not be overexposed to those that do cut their dividend.

If investors want to invest in equities through a collective investment scheme, but cannot decide on which one, simply looking at the yield is an effective way of identifying the cheapest. It is important to make sure the comparisons are valid so the selection must be made within the same asset class. Once the short list is assembled selection by yield enables the investor to make a quick and simple comparison between different cost structures, investment approaches and investment vehicles, even passive versus active. All else being equal, the fund with the highest yield should provide the cheapest way of accessing the asset class.


Disclaimer:  

Past performance is not a guide to future returns. The value of investments and the income from them may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. For risks relating to specific products, please refer to the relevant documentation for that product.


Do you like this Post?
Yes
No
0 thumbs up
0 thumbs down
Share this post with friends



Ocado Group plc is a United Kingdom-based online grocery retailer. The Company's principal activities are grocery retailing and the development and monetization of Intellectual Property (IP) and technology used for the online retailing, logistics and distribution of grocery and consumer goods, derived from the United Kingdom. The Company offers end-to-end operating solution for online grocery retail based on technology and IP, suitable for operating its own retail business and those of its commercial partners. The Company's brands include Ocado, Ocado Smart Platform, Sizzle, Fetch and Fabled. Sizzle is a kitchen and dining store. Its beauty store is in partnership with Marie Claire. The Company's Ocado Smart Platform is a solution for operating online retail businesses. The Company's Ocado Smart Platform combines its end-to-end software and technology systems with its physical fulfilment asset solution. more »

LSE Price
897.6p
Change
-0.7%
Mkt Cap (£m)
6,252
P/E (fwd)
n/a
Yield (fwd)
n/a



  Is LON:OCDO fundamentally strong or weak? Find out More »


What's your view on this thread? Log In to Comment Now

You can track all @StockoChat comments via Twitter




Stock Picking Tutorial Centre



Let’s get you setup so you get the most out of our service
Done, Let's add some stocks
Brilliant - You've created a folio! Now let's add some stocks to it.

  • Apple (AAPL)

  • Shell (RDSA)

  • Twitter (TWTR)

  • Volkswagon AG (VOK)

  • McDonalds (MCD)

  • Vodafone (VOD)

  • Barratt Homes (BDEV)

  • Microsoft (MSFT)

  • Tesco (TSCO)
Save and show me my analysis