How managers pick a game-plan

How does a fund decide on the right investment strategy for your money? Ken Welsby reports

Whether you are looking at unit trusts or investment trusts, it's always a good idea to try to understand the fund manager's investment strategy: how he decides which shares to invest in. For many managers, the starting point will be a broad overall view of the economy. This may be a "top down" policy decision taken at board level or it may be a consensus reached by individual managers in joint discussions. However the decision is reached, individual managers are expected to "toe the party line" - although they will generally have some discretion over timing.

As an example of this kind of corporate policy, many management companies have recently decided to increase the proportion of their funds held in cash. This is based on the belief that share prices - which on the London stock market are reaching record highs - are likely to fall over the next few months, while interest rates will rise. So, say fund managers, it makes sense to keep more cash on deposit at the bank rather than spending it on shares which could be worth less in three or four months' time than they are today.

This kind of investment policy is not normally controversial, unless it is taken to extremes. For example PDFM, a highly-respected fund manager, attracted much comment recently when it became known that it was holding up to 15 per cent of its funds in cash - bank deposits and the like - rather than investing in stocks and shares. This compares with 5-7 per cent held in cash by most other fund managers.

In many cases the broad investment strategy of a fund is obvious from its name. For instance Prolific's Recovery Trust invests in companies which benefit early on from an upturn in the economy. John Thornton, the fund manager, says that recently this has entailed a heavier investment in companies involved in building materials, construction and retailing - businesses "which have entered a phase of corporate self-help through cost cutting and rationalisation".

There is also the prospect of further mergers and acquisitions in these industries. If successful companies are finding it difficult to increase sales and profits from their existing operations they will start to focus on what the City calls "undervalued opportunities". These are companies whose growth potential is not yet reflected in the price of their shares. This process is known as stock selection, and managers invest much time and effort studying the performance of individual companies before making their decisions.

But some funds work in a dramatically different way, based on statistical analysis of the stock market. In this approach, it does not matter what the company does - or even what profits it earns - provided it meets certain criteria. For example, Johnson Fry uses a system known as Hy5 to pick the shares for one of its funds. It works like this:

l Start with the FT30 Index - the top 30 companies on the London stock market - and look at their yields (gross dividend as a percentage of the share price).

l Draw up a shortlist of the 10 shares with the highest yields, and then look at their share prices.

l Pick the five of these with the cheapest prices, and buy them.

It sounds incredibly simple - but Johnson Fry claims that it has tested this formula on stock market data for the past 26 years and it works.

Another aspect of strategy which can attract public attention is the question of what to do with the duds - shares in companies that fail to live up to expectations and, over time, grow less and earn less than others in similar industries. This is known as underperformance, and traditionally, fund managers in this situation simply sell out and find another company in which to invest.

But times are changing. M&G, one of the giants of the investment management business, is committed to the concept of "constructive dialogue" with the senior managers of companies in which its funds have a significant interest, and makes a point of getting to know them.

"We take a long-term view of performance and we are not deflected by short-term considerations," says M&G. "We do not attempt to tell management how to run their businesses, but, if a company's actions seem likely to jeopardise the interests of shareholders, we find that constructive intervention can often be preferable to disposing of our holding"n