Funds need to have objectives and constraints so that potential investors can have some confidence about how the fund will be managed and what assets it will contain. Investors also need to be able to hold the fund managers accountable for the performance of the fund.
The constraints of the fund ensure that it does what it says on the tin. For example, a European bond fund shouldn’t be buying US equities. Constraints also help the fund keep within risk limits.
In framing the objective of their fund, the creators of the fund (typically ‘product managers’ in liaison with sales executives at the company) generally have a choice between two types of objective. The fund can either have a ‘target return’ objective, or a ‘benchmark relative’ objective.
A fund with a target return objective will, for example, aim to achieve a return of 5% per annum on average over the medium term (often over the course of a ‘market cycle’, or on average over the course of 5-10 years). The target might instead be expressed as ‘cash+5%’, whereby the target is to achieve returns of 5% (per annum on average over the medium term) in excess of the prevailing cash interest rate. Similarly, the target could be expressed in excess of inflation, whereby the target is then a real return target.
A fund with a benchmark relative objective will aim to achieve a return in excess of a benchmark. The benchmark might also define the constraints of the fund and the universe of allowable investments. For example, a fund benchmarked against the FTSE100 might only be allowed to buy stocks that are in that index. Although stated objectives are often to beat the benchmark over a medium-term period, it is inevitable that fund managers will be evaluated over shorter time periods too.
For both types of objective, risk as well as return objectives will normally be stated. For example, a target-return fund might have an absolute volatility limit/constraint/target/expectation (the management company could frame it in any number of ways) of about 8-10% p.a., on average over the medium term. In practice, a target return fund could express its risk objective in relative terms, such as ‘half the risk of global equities’. A benchmark relative portfolio’s risk objective or constraint will generally be expressed relative to the benchmark, in the form of ‘tracking error’.
There are pros and cons of each, which we lay out in the table below
The greater accountability of benchmark relative portfolios is key for us. Whether or not you’re actually going to call up your fund manager and hold them accountable is not important. What is important is that if you invest in a U.K.-equity fund, you get U.K.-equity-like performance. A target return portfolio could find any number of ways to explain away the performance of the fund, and you won’t likely have grounds for complaint because the language in the documentation is loose enough to allow significant ‘underperformance’ for significant periods of time. Particularly in the case where you’re building your own portfolio, we suggest sticking to funds with benchmark-relative objectives, so you know what you’re getting for each component of your portfolio.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
Thanks for reading. Sign up to receive some or all our new posts by registering your email address
To the pound 