The fallacy of ‘best buy’ lists

James McManus


4 min read

After an investor exodus at a widely endorsed equity fund, we ask, are “best buy” lists a good guide for investors? Evidence suggests they are not.

Falling Arrow Chart

The problems of the Woodford Equity Income Fund are widely reported. Following market losses, so many investors demanded their money back that the fund’s authorised corporate director chose, on 3rd June, to suspend redemptions1. The events are damaging to the reputation of Neil Woodford, a former “star” manager who set up the fund five years ago, and no doubt frustrating for the many clients who would like to get their money back, but currently can’t.

It is likely that some of the investors in the fund chose it because it was recommended on the “best buy” lists of investment platforms. Hargreaves Lansdown, for instance, highlighted the fund in its Wealth 50 list of favourite funds and, as of last year, users of the firm’s platform accounted for approximately £1.4 billion of the £3.7 billion in the fund2. Following the suspension of the fund’s trading, Hargreaves Lansdown removed the Woodford Equity Income Fund as well as the Woodford Income Focus Fund from its Wealth 50 list3, which, for many commentators, has called into question whether “best buy” lists are a good guide for investors.

Investors who bought the Woodford fund based on recommendations in a “best buy” list might regret receiving the tipoff. But the problem is bigger than just one fund. We believe “best buy” lists are nearly always a poor guide to selecting investments. Here’s why.

Damning underperformance

Investing can be complex. Saving for retirement, for example, may be the biggest financial commitment we make in our lifetimes, alongside that of purchasing property. “Best buy” lists are popular because they highlight a limited number of funds, endorsed by expert analysis, which may be offered at a discount to the list price.

But what about the evidence? First, let’s address the chances of selecting a stock-picker that outperforms. Standard & Poor’s (S&P) is one of the world’s largest financial data companies. Many well-known stock indices bear the name, for example the S&P 500, the index of the largest 500 companies in the United States. S&P regularly publishes a report on the performance of fund managers globally, which as we’ve discussed before highlights the damning scale of underperformance. The below table provides little comfort for those putting their faith in stock pickers in major developed market shares.

SPIVA scorecard, June 2018 by S&P Dow Jones Indices LLC

At Nutmeg, we believe that asset allocation – the mix of asset classes in a portfolio – is the primary driver of returns over the long term. This view is widely supported in academic and practitioner research, including the landmark 1986 study by Brinson, Hood and Beebower entitled ‘Determinants of Portfolio Performance’, which conclude that on average over 90% of portfolio volatility can be explained by asset allocation.

Taken together, this information should raise significant concern for investors using “best buy” lists, as the key conclusions are:

  1. Asset allocation, not stock selection, is the dominant driver of returns
  2. Within stock selection there is a limited chance of selecting a fund manager that can outperform sustainably over the long term.

Put simply, picking the best funds alone isn’t enough as these decisions only account for only a small portion of the overall returns needed to meet your investment goals.

What does the regulator say?

In 2017, the UK’s Financial Conduct Authority (FCA) published a study of the “best buy” lists offered by the three largest UK fund platforms4. It noted that, collectively, these three platforms had a market share of more than half of assets under administration in the UK. What the study found will be little comfort to investors who use “best buy” lists.

When assessing the drivers for recommendation of funds, the FCA found that funds affiliated with the platform are “significantly more likely to be added to the recommendation list than non-affiliated funds” while at the same time “are less likely to be deleted from recommendation lists”. The study also found that “recommended funds share a higher proportion of their revenues with the platforms than non-recommended funds”.

Most critically, the FCA study looked at whether these recommendations added value for investors by outperforming the market and concluded that “over our 10-year sample period, a portfolio comprising all funds recommended by platforms delivered average net returns in excess of Morningstar category benchmarks of 0.08% per year”.

It is not just the regulator that has been critical of how these funds are selected. Terry Smith, a respected fund manager and founder of investment firm Fundsmith, recently voiced concerns over how Hargreaves Lansdown selects its recommended funds. Smith was quoted in the Times as saying, “recommended funds continue to be chosen mainly for fund managers’ willingness to comply with a charging structure which enables Hargreaves Lansdown to maximise its own profitability, and not because they perform well for investors”5.

How can Nutmeg help?

Nutmeg was created to provide an alternative to the status quo. We believe that all investors should be offered access to a professionally managed investment portfolio, suitable to meet their individual investment goals, at a fair price. Our expert investment team build low cost, diversified and risk balanced portfolios to meet your needs.

If you’re interested in how your existing portfolio compares with Nutmeg on cost, take advantage of our Portfolio Review Service. Our experts will provide a detailed, non-biased analysis of your portfolio free of charge, to give you a clear and accurate picture of where you stand. Find out more here.

This article was updated on 6th June to clarify that the 1986 study, ‘Determinants of Portfolio Performance’, found that 90% of portfolio volatility can be explained by asset allocation rather than 90% of returns as was stated in an earlier version.

Sources

  1. https://woodfordfunds.com/statement-on-lf-woodford-equity-income-fund/
  2. https://citywire.co.uk/investment-trust-insider/news/hargreaves-shares-dive-on-woodford-fund-suspension-fallout/a1235246
  3. https://www.hl.co.uk/news/articles/woodford-equity-income-all-dealing-suspended-following-redemption-concerns
  4. https://fca.org.uk/publication/occasional-papers/occasional-paper-30.pdf
  5. https://www.moneymarketing.co.uk/528135-2/

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Tax treatments depend on individual circumstances and may be subject to change in the future. Past or future performance indicators are not a reliable indicator of future performance.

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James McManus

A self-confessed ETF geek, James is head of ETF research at Nutmeg. He joined in 2015 from Coutts & Co, where he was an associate director in the investment office. James holds a Bsc (Hons) in International Business from Nottingham Business School.


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