How to perform a deep dive on funds, investment trusts and ETFs

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When researching funds, investment trusts, and exchange-traded funds (ETFs), it’s important to look under the bonnet. But what does that entail? To explain how to understand how funds invest and the key things to look out for, Kyle is joined by Dave Baxter. The duo draw on their experiences of researching funds and interviewing fund managers to provide plenty of helpful pointers.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On the Money, a weekly look at how to make the most out of your savings and investments.

There’s now less than two months before tax year end, and we thought it’d be very timely to do an episode in which we explain research tactics when it comes to funds, investment trusts, and exchange-traded funds (ETFs).

We’ve spoken a lot previously on this podcast about the importance of looking under the bonnet when researching funds and today, we thought we’d talk through the key tactics.

Joining me to discuss this is Dave Baxter, senior fund content specialist at interactive investor.

We’ll split the discussion into three parts, and cover funds, trusts, and end with ETFs and index funds.

So, let’s start with funds. What are the main things for investors to consider when they start researching funds?

Dave Baxter, senior fund content specialist at interactive investor: There is, of course, the disclaimer that past performance is not a guide to future returns, but performance does still matter. You should look at performance, but it’s important to give adequate context.

So, there are two thoughts I have here. One is you want to compare like for like. So, say you’re looking at a fund like Fundsmith Equity I Acc, a quality growth-type fund. You’d want to compare it against other global equity funds with that kind of bias rather than, for example, something much racier like Scottish Mortgage Ord (LSE:SMT).

The second thing that’s really important is time frames and context. So, don’t simply look at whether a fund has performed best for five years, although that is useful. You want to additionally look at how it’s done in certain market conditions. So, if you had a period in which, say, a growth fund or growth funds in general have done well, you would expect a growth fund you’re looking at to also have done well.

Equally, in 2022 for example, we had interest rates rising and funds like Scottish Mortgage really struggled. So, you want it to be doing well and badly when you would expect that to happen. As I said, compare it with rivals and adequate benchmarks.

Kyle Caldwell: Funds are grouped in different sectors, and as you’ve mentioned, you’re not always comparing apples with apples.

With the UK All Companies sector, for example, the last time I checked, there’s around 250 to 300 funds-plus in that sector. Some will have a growth focus, some will have a value focus. As you’ve already mentioned, it’s not really telling you that much comparing the performance between two completely different fund styles.

Another thing to consider is whether the fund manager is investing in a certain part of the market. Are they focusing on larger companies, or do they have a remit to invest in large, medium-sized, and smaller companies? Again, it’s not telling you much if you’re not comparing like with like.

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Dave Baxter: As I briefly alluded to, it’s also important to pick the correct benchmark. If you look a fund factsheet, it will state a benchmark. Some of these are not necessarily the most adequate. You sometimes get funds comparing their returns to, for example, how cash is performing, which is a bit lenient. You want them to be comparing against the most widely followed market.

For example, if you’re looking at UK equity funds, you might be comparing [performance] with the FTSE All-Share. If you’re a global fund, you might be comparing with the MSCI World, although looking at the composition of the fund will tell you a lot.

For example, the MSCI World, as we’ve discussed many times, is very US heavy. So, if you’re a fund that’s US light, then you would expect to outperform, for example, last year when the US struggled. But in some previous years when the US raced ahead, you might not expect to beat the market.

Kyle Caldwell: I completely agree. In terms of what funds pit their performance against, I think it should be the most comparable benchmark there is for that fund.

I’ve seen instances where a fund compares its performance against the fund sector it sits in. I think that’s a bit disingenuous because if investors are sizing up an actively managed fund, then the main competitor is an index fund or an ETF that’s investing in the same market. The actively managed fund should be showing investors that it has the potential to outperform the index for x, y and z reasons because it invests sufficiently differently away from the index.

Dave Baxter: It’s also worth noting that some sectors are really disparate and the average masks a lot of difference. So, if you look at the Investment Association (IA) global sector, yes, you’ll have those well-known funds like your Fundsmith Equity, your Scottish Mortgage and so on. But you also have some very niche funds like water funds, that kind of thing. So, it’s not always the most useful metric.

Kyle Caldwell: You’ve already touched on the fund factsheet. So, this is a two or three-page document that gives a snapshot of how the fund invests. It’s a very useful document, although it has its limitations.

Most fund factsheets have to show, well, I don’t think they are mandated to, but most show the top 10 holdings, which does give a flavour of how the fund manager invests.

I also think it’s a good indication of whether the fund is investing sufficiently differently from the wider index. So, say it’s a UK fund and you see a lot of the biggest companies in the top 10 holdings of an active fund that are also in the FTSE 100 index, the top end of the FTSE 100, then, for me, that’s a potential sign that the active fund’s not being active enough.

Dave Baxter: Yeah. Also, I think factsheets give you a good sense of, well, obviously, what you’re invested in, but the top 10 holdings list can be really useful, especially if it’s quite a concentrated fund. So, if we want to go for a really extreme example of this, one of Nick Train’s funds will have multiple positions of, say, 12% weightings, to things like Experian (LSE:EXPN), RELX (LSE:REL), the stocks have been struggling this week actually.

But having said that, there are funds that are a lot less concentrated. To name one popular example, Ranmore Global Equity Institutional GBP has pretty small position sizes, like 2% or so. When that’s the case, you want to agonize less over the top holdings and look more at the sector weightings and regional weightings, if it’s something like a global fund. Then, as you mentioned, you want to compare it to the index and see, if it’s a global fund, whether they are taking a big US bet, or are they going somewhere else? That kind of thing.

Kyle Caldwell: Also with global funds, just by looking at the country weightings, it can give you an indication straight away about whether the fund just sticks to developed markets, or whether it also has some exposure to Asia-Pacific and emerging market regions.

My view on this is that global funds should use the full global remit. If you just stick to developed markets, it’s going to be more common that you will see a higher proportion in percentage terms in the US market due to that.

Dave Baxter: Yeah. It’ll be interesting on that note to see how much global managers drift back into China and South Korea because they are sort of back on the rise.

Kyle Caldwell: Another very useful key ratio, although it’s not widely available, is the active share ratio. In a nutshell, and I’m explaining this in a very quick way, the higher the percentage of the active share ratio, the more active the fund is versus a comparable index.

Now, if I was a cynic, I would say that fund firms that publish the active share ratio, or the funds that publish it, they tend to have a high percentage weighting...

Dave Baxter: Baillie Gifford, that kind of thing?

Kyle Caldwell: Yeah. But I would like to see this more widely adopted. But unfortunately, there’s no regulatory requirements for this data point to be published. But I do think it’s a very useful metric when it is available.

Dave Baxter: It’s also worth noting, you mentioned before that the factsheet is very useful, but that it also has its limitations, my two cents. It’s interesting that different companies can vary by how detailed or forthcoming they are. So, some go into all sorts of different metrics and will also provide a commentary, so you have an idea of what they’ve been thinking that month, what they’ve been buying, selling, that kind of thing.

Whereas some others, and, for example, Baillie Gifford is one of these, I think, even though it does the active share, it can be quite bare bones. So, you need to dig a bit deeper to work out what’s going on.

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Kyle Caldwell: I agree, Dave. I think in terms of the information that investors receive from fund firms through that document, some go into great levels of detail on a monthly basis. Others don’t really provide much of an update. As you say, it’s like the bare bones, really. Investors aren’t being informed in terms of what the fund manager has been doing, or the portfolio activity in recent months.

In regards to the fund manager, I think it’s important to consider how long they’ve been running money for. If it’s more of a team-based approach, [consider] how long the team has been together as well. Because, like in many other things in life, I think experience counts for a lot.

Investors may be comforted if a fund manager’s been in his or her post for a long time, and they’ve been investing through multiple different economic and business cycles. For example, they’ve seen interest rates at rock-bottom levels, and at higher levels, and they’ve been able to navigate those events accordingly. If you see that a fund manager’s been running money for 10, 15 years-plus, then it’s probably quite likely that their performance has kept them in the job.

Dave Baxter: It’s interesting also, as you mentioned, that I suppose we’re seeing a bit of a fading of the star manager culture where you’d have a big name. Fund firms love to stress how much they’re doing this team approach, and how it doesn’t matter so much if someone leaves. But I think it does make a difference who the lead manager is because those individuals can have specific opinions on a sector or a given stock, and it can materially alter what’s in the portfolio.

Kyle Caldwell: I completely agree. I think particularly for retail investors, it’s very important that there’s accountability when it’s a team-based approach, that there are named fund managers.

When there are periods when the fund falls out of form, for example, it could be due to the style the fund adopts, such as a value or growth focus - these styles do go in and out of favour over different time periods. When that happens, it’s important that the fund manager communicates and gets across to investors the reasons why the fund has been underperforming. Essentially, it’s important that they don’t hide and there’s someone who is accountable.

Another point I wanted to make is that there are certain fund firms that specialise in a certain asset class or investment style, such as value.

Dave Baxter: A couple of examples that I was going to throw up, say, if you take bonds, some people think they are boring, but it’s a very technical and specialist area. For example, there’s a firm called TwentyFour and they are very good at focusing on these really esoteric and niche parts of the bond market.

Then, on the staff front, you have value firms, or say you want to look at the growth style, Baillie Gifford. It’s an interesting argument about whether you should favour those specialist firms or whether you should trust the generalists because some of the really big asset managers, for example Janus Henderson, they cover everything.

Kyle Caldwell: The final point I want to make before we move on to investment trusts is going back to the point you made at the start, Dave, regarding performance.

If you go on to a website such as Trustnet, you could plot the returns of a fund versus an index. If you do this, say, over a 10-year time period on a line chart, if those two lines are similar, then, for me, that indicates straight away that the funds may not be active enough because otherwise, why is the performance so similar to an index?

Let’s now move on to investment trusts. More seasoned investors will be familiar with the various bells and whistles of  investment trusts. When you’re researching investment trusts, you do have to consider the structural differences that they have compared to funds. This includes the ability to gear, which means the ability to borrow to invest.

In a rising market, gearing can boost performance. However, it’s a double-edged sword. If it’s a falling market and an investment trust is geared, then the losses will be greater.

Investment trusts have two parts, a share price and their net asset value. This is called the NAV. So, this is the value of the underlying investments held by the investment trust. If the share price trades above the net asset value, then an investment trust trades on a premium.

Whereas if the opposite occurs, if the trust’s share price is trading below the net asset value, then a trust is trading on a discount. In this scenario, you have the chance to buy the trust for less than the sum of its parts.

But as you’re going to come on to in a moment, Dave, it doesn’t always mean that investors can pick up a potential bargain.

Dave Baxter: With discounts, there are a couple of areas where I disagree with the consensus a bit.

One is, as you say, it’s not definitely a bargain. It can still struggle. It can still stay on a discount for a long time. Some of these discounts are just structural features of the industry.

My other big bugbear that I love going on about is the fact that I think people worry too much about discounts, particularly institutional investors. We’re seeing activists like Saba complaining about discounts, and trust boards coming under a lot of pressure to remove them.

But - and the private equity sector is a really good example - you can have trusts in sectors that are on huge discounts for many, many years. But what you are getting is the share price performance, and you are still getting good returns. So, that’s really what matters to me.

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Kyle Caldwell: I think what you’ve got to think about is that, ultimately, it’s the performance that will drive the long-term returns of the investment trust. So, you shouldn’t be buying thinking it’s on a massive discount if it doesn’t have a compelling investment story, for example.

However, certain investment trusts have policies in place where they’ll buy back shares at a certain percentage discount. So, if investors are aware of them and they see, for example, an investment trust trading on a discount of 10%, and the board has a policy in place where it doesn’t let the discount get above 10%, then that could be quite a good opportunity to buy in at that point.

But you need to also look at the bigger picture and buy because you think on a medium- to long-term view that it could outperform and outperform competitors. So, [ensure] you are not just buying it purely for the discount alone.

Dave Baxter: Yeah. I worry more about premiums, although they are quite rare. But if you look at, say, the Association of Investment Companies (AIC) site you can see this, because then you’re potentially having a long way to fall if things go wrong.

Kyle Caldwell: Yeah. It’s always hard to put a number on it, but I would be a little bit wary if a premium is above 5%. I’d certainly be very careful if it was 10% or more. We’ve seen various examples over the years of hype, and investment trust premiums simply being unsustainable.

The one example that jumps out to me the most is Lindsell Train Ord (LSE:LTI) Investment Trust. I think at one point, several years ago, the premium was at, or very close to, 100%. Now, it’s trading on a discount.

Another more recent example is 3i Group Ord (LSE:III). Again, I think about 12 months, 18 months ago, the premium was as high as around 60%. That has since cooled, and I think it’s around 10 to 15% now at the time of this recording.

Ultimately, these high premiums can’t be sustained and they can’t last forever. You’re paying a huge amount higher than the value of the underlying assets are worth.

Dave Baxter: Yeah. I think it’s a definite red flag. Like, normally, there are reasons people roll out for those premiums, aren’t there? Like, 3i is the only way to access that high-growth discount European retailer, Action. But nevertheless, as you say, it can be a problem.

Kyle Caldwell: Another structural difference investment trusts have over funds is the ability to squirrel away 15% of income generated each year into what is known as a revenue reserve.

This is why we have a number of investment trusts that have outstanding track records of growing their dividends year in, year out. There are 10 that have increased their dividends for 50 years or more. The one with the longest track record is City of London Ord (LSE:CTY) Investment Trust. It has raised its dividend every year since 1966.

However, I just want to point out that the way these revenue reserves work is that, say there’s a bear market for dividends and the amount of income being generated by the investments doesn’t meet the amount that the investment trust needs to maintain or increase the dividend. They’ll then dip into what is known as the revenue reserves to fund the shortfall. However, it’s not a separate pot of money, but part of the investment trust’s underlying investments. So, the fund manager has to sell or take profits from some investments to increase the dividends.

Dave Baxter: Yeah. It definitely has its drawbacks. But it really comes through in times of crisis, the obvious one being 2020 when UK companies paused or cut their dividends all over the place. I think there were a couple of trusts, maybe Temple Bar cut its dividend, but most of them maintained or increased it.

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Kyle Caldwell: In terms of the bells and whistles that investment trusts have, this is one that benefits private investors the most. Particularly, maybe if you are in the later stages of your investment journey, and trying to find some income-producing investments.

Ideally, you’re looking for income-producing investments that are going to be maintained or increase in value. All things being equal, these investment trusts have really long-term records of growing their dividends through thick and thin, and chances are that they are going to be maintained over time.

I think it’s going to be a last resort if an investment trust board decides to cut dividends if they have these long track records.

A really useful tool for investors looking at the health of these revenue reserves is on the AIC website. It lists the number of years and months an investment trust has in revenue reserves. So, say for instance it’s one year, this means that if the investment trust doesn’t receive any dividends from their underlying investments, they have one year’s worth of reserves that they can use to maintain or increase the dividend.

Dave Baxter: Yeah, and generally, when we’re talking about assessing trusts, it should be noted that the AIC site is really very impressive. It shows you discounts, dividend data, revenue reserves, charges, and it has links to documents of research and fund factsheets. It’s a really good starting point if you’re a budding investment trust investor.

Kyle Caldwell: But one thing to watch out for is that for these investment trusts to have really long-term records, some of them trade on a really small dividend yield. So, if you’re a new investor, you’re not really getting that much income.

You might get the income growth, but it’s from a pretty low level. Some dividend heroes are yielding 2.5% or less. If you’re an income investor, you might take the view that it’s not high enough to even interest you.

Dave Baxter: I always find it quite bizarre that Scottish Mortgage is a dividend hero. It must have a yield of under 1%, but it just happens to have increased it over that period of time.

Kyle Caldwell: I also find it bizarre, Dave, that Scottish Mortgage pays a dividend. I’m a shareholder in Scottish Mortgage, which we’ve spoken about before on a podcast we did earlier this year, where we explained how we’ve both invested over the years.

I voted against the dividend being increased in the Scottish Mortgage annual general meeting. I think it was last summer. But I was massively in the minority - 99% of shareholders approved the dividend increase.

For me, it’s a growth-focused portfolio, and that’s why I’m buying it. I don’t want the dividend and that’s why I reinvest it. But, obviously, there are a lot of shareholders who voted for it who want this rising income stream.

In terms of the information that investment trusts produce, I think trusts are more transparent and offer a lot more information to private investors.

Some of this is because trusts are listed on the London Stock Exchange, so they have to produce half-yearly and full-year results.

You get a lot of commentary in those results from the fund manager and the chair about what the trust has been doing, how it has performed, which shares it introduced to the portfolio over that year, and which ones it sold.

You can get a good sense of the investor sentiment and whether the fund manager’s feeling particularly bullish or whether they’re being a bit more cautious.

Of course, a fund manager’s always going to want to talk up his or her book, but sometimes you can read between the lines, and sometimes they are not as optimistic, or not as positive, as they have been in the past.

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Dave Baxter: I agree and I think that with open-ended funds you’re much more at the mercy of how much a manager wants to do commentary or discuss things, and they might do that on the fund firm’s website, but some just really don’t tell you much and it’s quite hard to work out what a fund does.

I was going to mention for the real, I suppose, fund geeks out there, that open-ended funds do technically publish a sort of annual report. That is sometimes useful because if you can dig it out on their website, you can see their full list of holdings at the time, but it’s nowhere near what trusts offer.

Kyle Caldwell: They can be quite hard to find. Obviously, we both do this for a day job, and sometimes I can’t find them, and I know where I’m going to try and find them as well.

The final point on investment trusts is that they can provide investors with exposure to more alternative assets. However, this does make investment trusts in certain cases more complicated than funds.

What are your thoughts, Dave, in terms of getting under the bonnet of these alternative asset investment trusts?

Dave Baxter: I think in those cases, often you do have to trust in the manager, so maybe you’re looking more at things like performance. To give you one example, with private equity trusts, some of these trusts will have a limited number of direct investments.

One example is Oakley Capital Investments Ord (LSE:OCI) , which is quite concentrated, but you get so-called funder funds like Pantheon International Ord (LSE:PIN), and HarbourVest Global Priv Equity Ord (LSE:HVPE), and they will have, I believe, hundreds of underlying holdings. So, you can attempt to look at what they are holding, but really it’s going be very complicated, lots of small positions.

Maybe you’re better off looking at the broader things like sector weightings. But in those cases you are potentially taking a bit more of a leap of faith with the manager, and you’re less able to assess it yourself.

Kyle Caldwell: Let’s now move on to our final section, which is index funds and ETFs. So, we’ve just discussed actively managed funds, those managed by professional investors.

Now, I think it’s really important to not just simply buy and hold an actively managed fund, and to do a review once or maybe twice a year. Review how the fund is performing versus peers, and versus a compatible index.

Over time, the fund manager and the team may change, and when that happens, you need to decide whether to hold or fold. Also, over time, there’ll come a point when a manager retires. So, you need to consider whether good succession planning has been in place.

If you buy an index fund or an ETF, you might think there’s less work involved and that you decide which index, theme, sector, and country you want to invest in. You might think you can just do that and buy and hold for 10 years.

However, it’s still very important to look under the bonnet because there are lots of instances of index funds or ETF investing in the same market or investing in the same theme, but doing it slightly, or in some cases vastly, differently.

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Dave Baxter: Yeah. As you said, there are lots of good examples. I’ll give you two. The first one is dividends targeting ETFs. We’ve seen lots in, say, the UK and globally that can generate nice yields.

But when you tend to get to those more niche areas where you’re trying to achieve something and you’re being a bit more active almost, you can have very different ways of trying to achieve that goal. So, with dividend ETFs, some of them will simply chase yield, so they go for the highest-yielding stocks in the UK.

Whereas there’s a so-called dividend aristocrats range that tends to only include companies that have, I believe, maintained or raised their dividend for at least seven years in a row. So, interesting differences there are, say, with the UK dividend ETFs, the one that has the seven-year requirement would not include names like Shell (LSE:SHEL) that cut their dividend in 2020. So, that is lacking energy exposure, which the other fund has, and the other fund has performed much better. So, that’s really quite a big difference in what the portfolio is.

The second broad example I’ll give is thematics. At the minute, AI is causing some problems in markets, but it’s quite interesting, and defence shares are doing incredibly well. But again, the defence ETFs can differ by how much they focus on industrial shares or cybersecurity-type areas, that kind of thing, and how concentrated they are, what parts of the world they focus on. So, you really do need to do your work, and I think those funds could potentially be a bit more susceptible to changes as well than a bog-standard global tracker.

Kyle Caldwell: But even with a bog-standard global tracker, some will have just exposure to developed markets, whereas others will have some exposure to the Asia Pacific and emerging market regions as well. That’s certainly one thing to watch out for. It’s a case of looking under the bonnet and seeing what index the index fund is tracking.

Then, if you’re comparing apples with apples, say there’s one global ETF versus another global ETF, and they both have exposure to the MSCI World Index, but one has a much lower fee than the other, then I think that makes your decision for you.

Dave Baxter: Yeah. The only exception to that rule I would give is that you could also look at the size of the ETF because, in theory, a bigger one offers you more liquidity, which cuts back on your trading costs. But if it’s in a popular area and it’s undercutting the competition, particularly things like global and the US, it does tend to grow pretty quickly.

Kyle Caldwell: In terms of research and ETFs, it varies from provider to provider, but I’m often pleasantly surprised to see that when I’m looking at an ETF for editorial purposes or for my own research, you can see all the holdings. You’re not just being given the top 10 holdings.

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Dave Baxter: Yeah. It’s incredible. You have to disclose your full portfolio and it’s also often pretty up to date. So, for iShares, the market leader that runs a lot of ETFs, you can go on to the individual page for a given ETF and look at, say, that day’s, or the day before’s, list of holdings, and perhaps download the full list.

There’s also just lots of other details. There’s often things like dividend yields and perhaps more niche metrics. Obviously, you won’t get things like commentaries in the way you would from an active fund, but you really can basically see the whole thing.

I suppose going back to things like thematic ETFs, there’s a lot of criticism of them in that they perhaps buy at a market peak. So, you might not want to hold one, but you might still use it for inspiration to judge, what is a cybersecurity stock? What’s a defence stock? In that case, that full level of disclosure is great because you can simply dig into everything it is invested in.

Kyle Caldwell: I think when it comes to thematic ETFs, they do require more monitoring in terms of their performance because they are more susceptible to blowing both hot and cold.

Whereas if you’ve got broad exposure to, say, a global index fund or a global ETF, you can tuck it away with confidence over the long term. You don’t need to monitor its performance because, ultimately, you’re owning the world.

However, as mentioned earlier, the composition of an index will change over time. A big change that’s happened for US markets, specifically the S&P 500 index, is that over the past decade, it’s become more and more concentrated. It’s become more and more reliant on the performance of a small number of companies, the big US technology giants, the so-called Magnificent Seven.

So, if you own both a US S&P 500 ETF and a global ETF, it’s important to look under the bonnet of both and ask, am I doubling up too much? Am I overlapping too much in terms of exposure? Are there other ways that I could gain exposure to both markets?

For example, you might consider pairing a global ETF with an ETF that’s equally weighted. They invest in companies in equal proportions. So, they’ll own 0.2% of every company in the S&P 500.

Dave Baxter: Yeah. It’s worth noting that the concentration issue does sometimes crop up for other bog-standard trackers.

A notable example is emerging market/Asia ETFs because the indices there tend to have a lot of exposure to China. So, even though we said those are good buy-and-hold investments, it’s worth understanding what’s actually in there.

Kyle Caldwell: That’s all we have time for. Dave, thank you for coming on.

Dave Baxter: Thanks for having me on.

Kyle Caldwell: That’s it for our latest On the Money podcast episode. I hope you’ve enjoyed it. We always love to hear from listeners, and you can get in touch by emailing OTM@ii.co.uk. As usual, you can find plenty of analysis on investments and pensions on the interactive investor website, which is ii.co.uk. I’ll see you again next week.