Funds of funds have become increasingly popular with investors over recent years, as the fund universe has expanded to the point at which there are now many more investment funds than listed shares. Such a wide choice requires specialist management expertise to sort out the potential outperformers from the also-rans, and one of the best teams in the business is that of New Star Asset Management, led by Mark Harris and supported by his long-standing colleague, Craig Heron.

Harris’s team currently numbers five, with Clare Bryant, Robert Jeffree and Helen Llorente joining Harris and Heron. ‘Four of us have been working together for a reasonable amount of time,’ explains Heron. ‘Mark and I started in January 2002 and Clare joined us in May 2002. Rob joined in August 2006 and Helen transferred over from the private client team at New Star at the end of last year.’

A fund for all occasions
The New Star team manages a range of fund of funds portfolios, catering for different levels of risk tolerance and including some specialist geographically focused portfolios. Heron says, ‘We manage a total of eight funds of funds, comprising five managed funds – two cautious, one balanced, one aggressive and one concentrated growth tactical asset allocation fund. Then we have specialist funds investing in Europe, Asia and the US, but the regional funds are pretty small. The bulk of the assets are in the managed portfolios.’

The idea behind a fund of funds is that, rather than investing directly in a portfolio of shares or bonds, the fund of funds manager selects a mix of other managers whose funds should outperform in specific areas to construct a portfolio that spreads risk while maintaining overall total returns.

Harris points out, ‘Our investors rely on us to construct portfolios that achieve the optimal balance between potential returns and risks. A fund of funds encapsulates all the benefits of active management and enhances investment diversification in a cost-effective way.’

Heron agrees, ‘We know that very few people are going to just buy one fund of funds, but we feel we can provide a good proportion of an investor’s core portfolio, depending on their risk profile. So, for example, we added the most recent launch, the cautious fund, in November 2005 to address the fact that we didn’t have a fund for investors who wanted to take that option.’

Equity thinking
He maintains that the team’s approach to selecting funds is very similar to the way in which other companies choose which shares to invest in: ‘We try to run our funds by thinking in the same way that the manager of directly invested equity funds would be thinking. If we just picked fund managers and expected them to do the job for us, the performance would be very disappointing. Last year it was very difficult to make money; fund managers who have done well over the previous four years wouldn’t have made you any money in 2007.’

Heron continues, ‘This means we have to be very active in our management. Our turnover levels are high, possibly even in excess of 100 per cent in any one year. Direct equity investors have in-built biases to particular styles. People inherently like to focus on different characteristics. What we do know is that different styles outperform and underperform at different stages of the cycle.

‘Our job is to spot that coming. Last year the right strategy was to be as far out of mid- and small-caps as is humanly possible. The great advantage of a fund of funds is that they can be style agnostic. We can do whatever it takes to make money for our clients.’

This reflects the fact that the universe of potential investments available to fund of funds managers is very broad and widening all the time. Heron says that ‘With the change in regulations that arrived in February last year, an awful lot of freedom as to what we can put in our portfolios [was granted]. We have always been able to invest in offshore funds, but now we can buy things like ETFs as well. Naturally, we have to stick to the spirit of what constitutes a fund of funds, but we can buy pretty much anything.’

Following a clear strategy
The key to successfully managing these portfolios is to have a clear long-term strategy. Harris says, ‘What influences our buying decisions are our strategic views – where we think we are in the cycle. Our view is that the market is right and if you are not in line with the market then you are wrong. That is a mistake that many fund managers make.

‘We want to limit the risk to our performance from asset allocation. Asset allocation is a driver of performance but is not necessarily well correlated with risk. The exception is the Tactical Asset Allocation fund which, of necessity, takes a more distinctive position.’

Despite the large number of funds to choose from, the actual portfolios are very concentrated. Heron explains that ‘The number of holdings is not affected by the size of the funds. The balanced funds have around 20 holdings, the active funds 15 and the tactical fund around 12. The funds investing in a single region can have as few as six holdings, although technically, under the new rules, you can have up to 35 per cent in any one fund. So our portfolios are very concentrated, but you have to remember that the underlying funds are very well spread. Each fund we invest in can have 50 or more holdings.’

He adds, ‘There are two main catalysts that will drive our buy and sell decisions. One is when our strategic view changes and we want to alter the balance of the portfolio to reflect that. The other is when we have bought a fund to fulfil a particular role. If it stops doing what we want it to, we have to find out why.’

Heron says, ‘We will also take money out of funds that have done very well. It is difficult to sustain dramatic outperformance or, indeed, underperformance. When we say that we have 100 per cent turnover, it doesn’t necessarily mean we are holding a different portfolio year after year.’

A question of style
Heron comments, ‘In terms of investment style, we would say that looking at whether a fund is value or growth is a starting point, but concentrating on style is an over-simplification. What constitutes a value stock is very clear, but growth is more opaque. Is the manager concentrating on high-quality growth or “growth at a reasonable price (GARP)”, for example?

‘We do pay a lot of attention to style and over the past year we have moved quite aggressively from value to growth. What you have seen is that some stocks such as utilities have been re-rated. Where they were once rated as value stocks,
they are now rated as growth stocks.’

Each member of the team has responsibility for specific funds. It was recently announced that Robert Jeffree will take over management of the New Star Asia Portfolio from Mark Harris, allowing him to concentrate on some of the managed portfolios – but they all contribute to New Star’s in-house fund research process.

Harris insists, ‘We don’t rely on any external analysis of funds. We do it all internally. We do quite a lot of statistical work on funds to see if there is statistical evidence that the fund manager is adding value. There is no need to see
the fund manager to work out if they can perform. Very often, the most important element is the investment style they adopt.’

This does not mean the team is sitting in an ivory tower. Contact with the managers they are assessing is vital and frequent. Harris continues, ‘Individual members of the team are given specific funds to monitor, so that we know where our largest exposures are. In other words, we make sure we know exactly what we own and we have the ability to pick up on fund changes on an intra-month basis. We speak to the fund managers at least once a month, sometimes weekly or even daily. At the very least, we would pick up any significant change at least once a month, when the valuation is received.’

Heron observes that the way in which the team measures the performance of their funds is distinctive and is a key element of their risk controls: ‘We are unusual in the market in that we benchmark our managed portfolios relative to their sectors. For example, with our two balanced funds, one is very low risk and looking for a pension fund-type return, while the other is slightly higher up the risk scale.’

He adds, ‘We get information from Lipper on the benchmark asset allocation in any given sector, so we know where we are in relation to the market as a whole. We also use styling software to identify what risks we are taking. We know what our biggest stock risks are and we make sure that we know those companies well.’