How to choose the right fund for your ISA

There are now just a few days left to take advantage of your annual ISA allowance (£11,520 investment ISA allowance for 2013/2014). With the paltry rates on offer for cash ISAs, many investors are looking to invest in funds instead.

Choosing which funds to invest in is always a tough decision and many investors have now been left to their own devices following the latest change in regulations. Needless to say investing in the right funds is incredibly important and can make an enormous difference to your investing success.

Those investors who got behind Neil Woodford early have reaped huge rewards. An £10,000 investment in his Invesco Perpetual High Income fund would be worth over £250,000 today in 1988. And there are many other funds which have had similarly spectacular returns. Just having one star performer in your portfolio can make all the difference in the long term.

But where do you start as a DIY investor. There are an overwhelmingly high number of funds, how do you find the ones which are right for you?

High-street bank funds

Even a small amount of research can put you ahead of the game. When investing in a fund many investors go with the first thing they see which is often a fund offered by their high street bank. Consider the following three funds from Halifax and their top five holdings:

Halifax Equity Income – Royal Dutch Shell, Vodafone, HSBC, Glaxosmithkline and BP
Halifax UK FTSE 100 Tracker – HSBC, Vodafone, BP, Royal Dutch Shell, Glaxosmithkline
Halifax UK Growth – HSBC, Vodafone, BP, Royal Dutch Shell, British American Tobacco

The holdings are almost exactly the same. An investor who bought the Equity Income and Growth funds might expect some diversification, but as you can see that's not the case. Perhaps not surprisingly, all these funds have underperformed their benchmark over the five years. What is more surprising is that between them these funds have assets worth £10 bn. Just avoiding these funds puts you ahead of many other investors.*

Performance

How a fund has performed in the past is the most obvious place to start when picking a fund. However, you shouldn’t expect stellar returns just by picking the best past performing funds. Some funds get lucky; some take excessive risk, some lose their managers, some lose key support staff or become too big to manage effectively. Often last years best funds don't do well the following year as a different type of stock or asset comes into fashion.

Choosing the right manager

When looking for a manager, choose one with a proven track record who has experienced all market conditions. The manager should be settled and unlikely to move in the near future. Make sure the manager is not managing too many other funds particularly if they have very different mandates. For example, avoid a manager who runs both a Japanese and UK fund. There is no reason he should be doing this. Does the manager and their team speak the language/s of the areas in which they are investing in. Are they based in or near to that region?

Always consider how well aligned a manager with their investors. Do they own the fund themselves? Finding managers who consistently outperform is not easy, but hundreds of managers have proven it can be done.

Understand the fund's mandate

It’s important that you choose a fund that is right for you and your own circumstances. Consider the past volatility and current yield for each fund. If you want income to fund your retirement you may want high income payers but remember this can come at the cost of lower capital returns.

You also want to carefully consider how much volatility you can take personally. What would you do if your investment falls 30%? Remember there will always be some sort of crisis; Ukraine, Europe, China or the financial crisis. If you’re investing for a long period, most equity markets will almost certainly suffer a major loss at some point. How would you react? Would you sell? If you couldn’t stand the loss, or it would keep you awake at night, you should probably consider investing in something less risky.

You also want to understand when you would expect your fund to do well and when you would expect it to do poorly. For example when the market is soaring you would expect your growth funds to outperform. Your defensive funds might underperform, but that doesn’t necessarily mean they are bad funds. The fund may actually be fine and it might subsequently claw back any underperformance when markets fall.

Always consider risk. Not all equity funds are the same. A biotech or technology fund is likely to be much more volatile than a fund which invests in high quality defensive companies.

Size

The size of a fund is important to consider. A small fund may lack the clout to get access to companies’ management. A fund provider may also dedicate fewer resources to it, instead assigning their strongest analysts to larger and more important funds. A small fund will typically have higher expenses.

However, a fund which is too large may also have problems. Firstly, it may be limited to only investing in larger companies. This is fine if the fund is expected to invest in large-cap companies but it can be a problem for funds which like to invest in small caps. If you own a small cap fund keep a watchful eye on how large it gets.
A larger fund also has an inherent competitive disadvantage to smaller funds. When a larger fund buys or sells shares it has a much bigger effect on the price of the underlying security. This ultimately means that unless a fund is very carefully managed a larger fund can often get a worse price when it buys or sells. They are also a lot less flexible. It is usually difficult for a large fund to exit from a big position quickly or to shift with the economic cycle.

Other things

Consider if your fund manager has the necessary resources to manage the fund effectively. Smaller fund providers may not be as effective at managing global funds or funds in faraway places which require a large number of bodies on the ground to be effective.

Also consider the turnover of the fund, or how much it trades. The more trades a fund makes the more costs that you the investor incur, although there are some funds which trade a lot and do very well.

Always be aware of the structure of your fund. Is it based offshore? Find out if the fund is covered in cases of fraud.

Building your portfolio

An investor should look to build a portfolio which is appropriate for their own circumstance. Most investors should invest in some funds with exposure to different parts of the world.

Don’t feel you have to invest in hundreds of funds. Remember one of the advantages of a fund is they already provide stock diversification for you. If you’re going to put the time in to find the next Neil Woodford you want to make sure his performance isn’t too diluted.

However, that being said, nor do you want to put all your eggs in one basket. It is usually a good idea to invest in a mix of different funds with different styles. Consider diversifying your portfolio further by adding some funds which invest in smaller companies (which historically have performed better over the longer term), although again be aware that smaller companies are inherently a lot more risky.

Avoid concentrating your portfolio all in one specialist area, such as Biotech, Technology, Oil and Gas or Commodities. Otherwise you risk experiencing very heavy losses at some point.

Stay up-to-date

After 25 years Neil Woodford has just left Invesco to start up his own fund. This shows how important it is for investors to keep a watch on their funds. What a fund invests in can change greatly especially when investing for a long period. Always try and review your funds periodically and consider re-weighting them if any one fund becomes too big a part of your portfolio.

By James Yardley, senior research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested,and tax rules can change over time. Darius' views are his own and do not constitute financial advice.