Dog days for UK investors

Funds that put your cash in British shares seem to be doing well - but they could do much better

You could be forgiven for feeling a little smug. If, that is, you're one of the millions who have held a UK equity fund - inside an individual savings account (ISA), perhaps - for the past three years.

Every last fund ranked by the Investment Management Association (IMA) inside its sprawling UK All Companies sector has risen in value since August 2003. If you had invested £1,000 back then in the average-performing fund, you would have £1,565 now - a rise of over 50 per cent and much greater than if you'd left your money sitting in a deposit account.

But while this may look impressive, delve a little deeper and it could be argued that most of these UK fund managers haven't been doing such a great job. The FTSE All-Share index, which represents most listed shares in the UK and is an ideal indicator of average performance across the stock market, has risen by some 60 per cent over the past three years.

Indeed, new research reveals that most UK fund managers have failed to keep up with this benchmark, let alone beat it, despite being paid fat fees by investors to do so. In the UK All Companies sector, nearly three-quarters of the 278 funds with a three-year track record failed to beat the FTSE All Share index over that period, says a report from "fund of funds" manager T Bailey.

The impact of a poor manager on your money will have been considerable. While the worst-performing fund in the UK All Companies index, JM Finn UK Portfolio, would have turned your £1,000 into just £1,230, the top-performing Saracen Growth Alpha would now be worth £2,170, says the Lipper ratings agency.

"As you might expect, there's a big difference between the best and worst funds in the sector," says Jason Britton of T Bailey. "But many will be surprised to learn that so many funds are actually underperforming the broader stock market. The figures prove there are a lot of poor managers out there."

But plenty of money still languishes in these funds, mainly because of apathy on the part of individual investors who don't have the time or inclination to keep a close eye on their money.

In July, independent financial adviser (IFA) Best- invest published its "Spot the Dog" listing to name and shame those funds that had underperformed against their benchmark over the previous three years. Billions of pounds of investors' money, it revealed, was tied up in ailing funds - and much of it with some of the best-known providers in the UK.

Biggest dog of all, said Bestinvest, was Prudential, with £2.4bn of investors' cash in its UK Growth fund.

Other household names it picked out for poor performance included the Halifax (and its Special Situations fund) and Norwich Union's UK Growth.

"Choosing a good fund is easier said than done - it involves a lot of homework," says Tim Cockerill of IFA Rowan. "For example, they range from ones that concentrate on mid-cap stocks, to highly diversified low- risk funds or those that invest in 'out of favour' companies," he adds.

While many investors choose a fund after seeing adverts, plenty of others use IFAs to help with their decision.

But many advisers don't have a specialist knowledge and may simply choose a fund for you that fits your attitude to risk but also pays the most commission.

One option for people who don't have the time or expertise to choose funds themselves is to consider investing in a fund-of-funds or multi-manager fund.

As the names suggest, these hold a portfolio of different funds that are scrutinised by the manager before they are selected.

By creaming off the top performers, many multi-managers have put in strong performances. However, a common criticism of this type of fund is the two layers of charging: you must pay the multi-manager as well as each of the separate managers of the underlying funds.

So the total expense ratio (TER) tends to be between 2 and 2.75 per cent, against 1.5 to 2 per cent on standard funds. Over time, these higher costs can make big inroads into your returns.

"Critics always focus on double charging, but there is value provided by multi-managers who have the skills and time to research funds thoroughly, which should result in choosing the best managers," says Mr Britton at T Bailey.

Kevin Tooze of IFA Equal Partners believes any reasonable sums of money should be placed with a fund of funds. "You can spread your cash across several funds in several sectors, so not all your eggs are in one basket."

Equal Partners recommends Jupiter Merlin Income fund and New Star Balanced Portfolio.