The best way to invest is to split the difference

Whether a fund does well or badly is all about risk, says Jenne Mannion. Two high-profile managers explain how they choose and handle their portfolios

Kitchen or Woodford? That is the conundrum facing followers of the successful fund management house Invesco Perpetual when they want to invest in one of the stable's three income funds.

When Invesco GT and Perpetual merged two years ago, two of the best managers in the business were brought together, Neil Woodford from Perpetual and Graham Kitchen from Invesco.

Mr Kitchen manages the £711m Income & Growth fund, and Mr Woodford runs the £2.4bn High Income and £802m Income funds. Both managers signed five-year contracts last spring, indicating their commitment to the company. But how should investors choose between the two?

All three funds aim for similar results. Mr Woodford's High Income and Income funds are managed similarly, but the former aims for a slightly higher yield, often through holding fixed-interest securities such as bonds. But the yield on High Income is not higher than the Income fund at present, both being on 4.2 per cent. Mr Kitchen's fund also has a similar estimated net yield.

Invesco Perpetual's idea behind retaining the two managers is to offer choice, because there is no requirement to obey a "house view" on stocks or sectors. So Mr Kitchen and Mr Woodford operate independently, with different styles. Mr Kitchen works from the group's London headquarters, and Mr Woodford is based in the former Perpetual stronghold of Henley-on-Thames in Oxfordshire. Rarely do the two speak about investment matters.

Mr Kitchen says: "It is entirely possible I might have a positive stance on banks, for example, and expect this sector to perform well, and at the same time, Neil might be bearish and have much less exposure to this sector, which is now the case".

Mr Woodford, 42, has the higher profile as word has spread about his skills and success since he took over management of the Perpetual funds 15 years ago. Mr Kitchen, 35, has been in the business for a slightly shorter time, but has managed his fund for eight years, still considered plenty in fund management terms.

Mr Woodford has delivered slightly better performance over the past five years. His High Income fund returned 18.55 per cent after all charges in that time compared to Kitchen's Income & Growth fund, which returned 1.11 per cent. Mr Woodford's fund is ranked eighth of 69 in the sector and Mr Kitchen's fund is ranked 24 of 69, show figures from Standard & Poor's.

Mark Dickson, head of product development at Invesco Perpetual, says although Mr Kitchen has historically had lower absolute performance, he has done so with a lower risk relative to the FTSE All Share index. Therefore, both funds have similar returns after allowing for the risk factor. "Expect higher returns with higher risk by investing in Mr Woodford's fund, or lower returns with less risk through Mr Kitchen's fund," Mr Dickson says.

Though both managers operate with similar targets and have few formal constraints, they tend to use different styles in achieving their performance. Both treat the FTSE All Share as their investable universe and both adopt a flexible approach, so neither can be pigeon-holed as growth or value managers.

In both of his funds, Mr Woodford combines a "top down" thematic view with valuation-driven company analysis in managing his funds. This means he will take views on certain sectors and this will affect the proportion of certain types of companies he holds within his funds. For example, Mr Woodford has only 3 per cent exposure to the banking sector, despite these types of companies representing 18 per cent of the FTSE All Share. This is because he expects banks as a whole have too much credit risk from bad debts. He also considers pharmaceutical companies to be too expensive, so he holds 3 per cent of his funds in this sector, much less than the index weighting of 10 per cent.

If he expects the dynamics of a certain sector are promising, Mr Woodford will hunt for the best companies in that sector. Certainly, he believes that insurance companies – which have suffered from poor sentiment – are unjustifiably cheap so he holds more than 7 per cent of his funds in these companies, though this industry grouping represents less than 1 per cent of the All Share.

This shows Mr Woodford's approach often results in aggressive sector weightings relative to the All Share index. In the nature of a high risk/high reward fund, there can be periods of underperformance. During the technology bubble of the late Nineties, Mr Woodford's portfolios drastically underperformed his sector, leading to strong criticism from investors and, as he has admitted, severe internal pressure.

But Mr Woodford's vision that the TMT rally would end in tears proved true and his funds have rebounded to the top of the performance league tables, while technology stocks have plummeted. Mr Kitchen continues to manage his fund by looking firstly at the merits of individual companies.

He tends to focus largely on stable companies with strong core businesses, high cash flow and low valuations. This investment style – of looking at individual companies – is called "bottom up" and is almost the opposite of "top down".

Sector weightings in Mr Kitchen's fund will result from the types of companies he found more attractive, rather than due to a common theme. Neither manager looks primarily at dividends when selecting stocks, rather the yield is more a by-product of their other investment decisions. Some companies will have high yields, and others may not be delivering a yield.

Mr Kitchen holds 60 to 70 companies in his fund, but Mr Woodford tends to hold a more diversified portfolio. The High Income fund now has 90 companies and the Income Fund 82.

One important difference between the two is that Mr Woodford will hold fixed-interest investments from time to time to boost the overall yield. In the late Eighties, Mr Woodford held almost 20 per cent fixed interest in his High Income fund, and Mr Kitchen has never held a bond or convertible loan stock.

All three funds are rated AA by Standard & Poor's, indicating that the rating agency considers the two managers' investment styles to be equally credible. One advantage with Mr Woodford's funds is that the annual management fee is less expensive at 1.25 per cent, compared to Mr Kitchen's Income & Growth, which is 1.5 per cent. This is a legacy of most funds at Perpetual being cheaper prior to the merger with Invesco, and the group management considers harmonising charges a low priority.

Mark Dampier, IFA at Hargreaves Lansdown, says rather than choosing which fund to opt for, he recommends splitting your money and investing in one from each manager. He says both of Mr Woodford's funds are managed similarly and have similar performance results. He expects the Income fund has a slight edge over High Income because it is only about one third the size, and so is less likely to suffer from a lack of liquidity when buying or selling smaller stocks.

"Because of the different styles of each manager, the two dovetail well together and different market conditions will lead one or the other to outperform," Mr Dampier says. "They are certainly complementary to one another. Neil Woodford certainly is better known, but it doesn't mean Graham Kitchen is any less good a fund manager. Both are excellent, and I would have total confidence investing in their funds in equal proportions."