Hard times breed a tougher kind of manager

Making a good return from equities is expected to be a hard slog. Even after a stock market recovery takes hold, the general view is that shares will return an average of 8 per cent a year, compared with the 20 per cent of the Eighties and Nineties. So fund managers must be more aggressive to achieve better returns, and hence a new breed of portfolio has become popular.

Generally called focused funds, this breed has highly concentrated portfolios of 30 to 40 stocks. A mainstream UK Growth portfolio would hold from 50 to 150 companies. In focused funds, managers take bigger risks on individual stocks through less diversification. This means good decisions are not diluted, but a wrong call will have a bigger impact on the portfolio.

Managers of focused funds tend not to be slaves to stock market indexes. Often, mainstream UK Growth fund managers will have to pay attention to the FTSE All Share and hold some of the larger companies such as BP, Vodafone and HSBC, even if negative on their prospects.

The concept of aggressive funds seems to work well. In many cases they have outperformed the more diversified mainstream portfolio offered by the same provider. (see table). Focused funds are available for other geographic regions

DWS has launched an equity income-focused fund called DWS Equity Income Plus, and in the same sector Credit Suisse offers a similar product called UK Alpha Income. The managers of these funds are looking for dividends, but the concept of a concentrated portfolio remains the same.

Juliet Schooling, an independent financial adviser at Chelsea Financial Services, says: "These funds set the scene for better returns. If a manager is holding only 30 or 40 stocks, they can watch them like a hawk. It is far more difficult to pay the same level of attention to a more diversified portfolio."

But focused funds should form part of a diversified portfolio, rather than be a core holding. The concentrated nature of these funds means that if a manager does make a wrong call on a stock, this will have a bigger impact on performance. So performance of focused funds is likely to be volatile.

Among focused funds Ms Schooling recommends are Gartmore UK Focus, Isis UK Prime, Unicorn Free Spirit and Schroder UK Alpha Plus. Richard Buxton has managed the £117m UK Alpha since its launched a year ago July and also manages the Schroder UK Growth investment trust, a mainstream portfolio.

Of the UK Alpha fund, Mr Buxton says: "It's about making lots of quick wins, taking a profit and moving on." Mr Buxton takes risks in his concentrated portfolio of 30 companies. Unlike many competitor funds, UK Alpha Plus has no resemblance to the UK stock market. Mr Buxton does not hold BP or Vodafone in this, although they are important constituents of the FTSE All Share index.

He is also prepared to avoid the big sectors of the All Share if he is negative about their prospects. He holds no exposure to the oil sector, despite this representing almost 14 per cent of the index. Mr Buxton, 39, joined Brown Shipley Asset Management in 1985 with an English degree from Oxford. He moved to Schroder in 2001 after 10 years at Baring Asset Management.

He will consider a stock attractive for Alpha Plus only if he can see it has 10 to 20 per cent upside. Last September, he bought Astra Zeneca at £18, and sold three weeks later at £23. But some stocks have been held over the life of the fund, including Royal Bank of Scotland, HSBC, ICap and Rio Tinto.

Mr Buxton's broader portfolio is the UK Growth investment trust. "It takes fewer risks and it is targeted at the medium-risk investor. It holds 50 companies and aims to outperform the FTSE All Share index by 2 per cent after charges, leading to much tighter stock and sector risk controls against this index." His portfolio cannot hold more than 3 per cent above its respective weighting in the All Share.

Performance of focused funds depends heavily on manager skills, so providers are introducing performance fees on this breed of fund. Most unit trusts charge a flat rate, generally 1.5 per cent a year, whether they perform brilliantly or poorly. But with performance fees you pay less if the fund performs poorly. The Gartmore UK Focus fund and Edinburgh Fund Managers UK Absolute Alpha fund are focused funds that offer such a performance-fee structure, and DWS UK Opportunities is likely to offer the choice of performance-related fees later this year.

The manager of the Gartmore UK Focus fund, Ashley Willing, also runs a hedge fund. Gartmore UK Focus is very actively traded. Mr Willing said it is not unusual to buy a stock in the morning and sell it that afternoon if it has risen significantly. Gartmore UK Focus holds 30 stocks and Mr Willing categorises these into long and short-term ideas. "I exploit every opportunity over the long and short term," he says. "Long-term ideas are good-quality stocks and will generally grow whether GDP growth is high or low.

"Cable & Wireless is a short- term holding. They had four profit warnings last year, and huge cash burn, but we did not hold it. The share price fell drastically due to over-reaction by the market to potential tax liabilities, which provided an attractive entry point. The share price has recovered with a new chief executive and the tax issue being resolved."

The Gartmore UK Focus fund's performance has particularly impressed since its launch in January, 2001, ranking first in the UK All Companies sector. Gartmore has fallen by only 0.45 per cent despite the sector average having fallen by a third.

Edinburgh Fund Managers launched its Absolute Alpha fund last October. The fund manager, Robert Waugh, runs a concentrated 25 to 35 stock portfolio, aiming for absolute returns rather than following an index. This fund can hold 100 per cent cash if the manager sees big stock-market falls.

Mr Waugh predicts a 100 per cent stock turnover for his fund in a year. Stock weightings are even, at 3 to 5 per cent, although he has held up to 9 per cent in one stock, GlaxoSmithKline. He finds abundant investment opportunities in mid-caps. These stocks represent 40 per cent of his fund. Main holdings include Royal Bank of Scotland, Imperial Tobacco and Icap.

Edinburgh UK Absolute Alpha is ranked 95 of 300 since it was launched last October, returning 6.83 per cent, compared with the sector average of 5.17 per cent.

'I'm comfortable because I balanced my savings with investment'

Gareth Cunnew, 32, a property development professional in London, used his Christmas bonus to invest in a focus fund. Last autumn, he put £3,000 in Isis UK Prime through a mini-Isa. Gareth, of Bexleyheath, south London, with his wife and three year old daughter, learnt about focused funds through the financial press.

"The big appeal for me was that unlike so many other funds, Isis UK Prime made it clear it wasn't trying to follow either the FTSE index or other investment funds. It just tries to generate as much return as it can without worrying what other fund managers are up to."

He realises the UK Prime fund is more risky than the average UK fund. But he believes the risk is worth taking.

"I still have savings in a deposit account, so I felt taking a slightly bigger risk with this part of my savings helped to balance it out. I'm comfortable with the risk because I invested money that isn't part of our monthly outgoings."

Isis UK Prime is the only fund Gareth has, but he plans to build his investment, using other bonuses. He will probably use other funds to diversify his portfolio.