Equity fund management
is often viewed as an easy option, in the long run equities have generally
delivered exceptional returns, outstripping other forms of investment
in most long term periods. The reality of equity fund management is
somewhat different, however, the market is highly competitive, with
an increasingly knowledgeable, demanding and sophisticated client base.
Equity fund managers returns are constantly compared with other
types of investment and to other fund managers. In addition, equity
managers are often constrained in terms of which securities they can
buy, since they need reliable data for a reasonably long period to enable
them to make sensible comparisons. Thus, few mainstream fund managers
would have included lastminute.com in their portfolios since little
or no analytical data was available for a reasonable time period.
There are many sources
of return and risk on equity portfolios. They include, but are no means
- Industry Group (energy, Financials, Technology)
- Economic Theme (eg consumer cyclicals, defensive, interest
rate sensitive etc)
- Beta (ie weighted average beta giving a measure of overall portfolio
- Company size (based on market capitalization)
Equity fund managers are broadly divided into two types, firstly those
seeking to achieve the highest possible capital return given the charter
of the fund. This charter specifies the market and the universe of securities
in which it can invest. The other types of manager are looking to provide
an element of income for investors, whilst protecting the clients
capital base from the ravages of inflation. In practice, there is little
difference in the way analysis is carried out for each, since it, does
not really matter whether dividends are paid out or retained.
The difference will come in terms of the actual stocks picked by the
fund manager when constructing his portfolio from the list of preferred
stocks (those with good prospects) prepared by the asset managements
house analyst. A growth fund manager will be looking to include stock
with the maximum potential for capital appreciation in a given time
horizon, whereas the income fund manager will be considered to include
stocks with a relatively high dividend held in order to achieve the
cash flow required for investors.
Both types of managers
will be judged against a benchmark. The measure of a successful fund
manager is to constantly beat the peer group benchmark. To achieve consistency
the equity fund manager and his research assistants must initially identify,
and then build a diversified portfolio from stocks that will out perform
other stocks in the indices that constitute the peer group benchmark.
The main source of return from equities is derived from increase in
the market price. Like any investment, the price of an equity should
be equal to the net present value of the cash flow received in the future
by the investor, although this model still holds for equities, it is
seen as a longer term relationship. In the short term, equity price
are often strongly influenced by prevailing general stock market conditions.
The long term relationship holds the key to whether equity is currently
over or under priced and is generally analyzed by looking at the earning
of the company. This earning may or may not be paid out to the investors
in the form of dividends, but nonetheless provide the basis of the fundamental
value of an equity. Like any net present value analysis, one of the
key factors relates to the interest rate expectations i.e. if interest
rates are expected to rise, then the NPV will fall. If earnings are
retained, the company can use them to grow the business.
Assuming that it has a sufficient number of new projects in which it
can achieve a worthwhile return. If we compare 1988 1992, performance
of ICI which traditionally paid a high dividend to Microsoft which re-invested
corporate earnings in research and development for new products etc.
we can see that the Microsoft investor would have benefited hugely for
Dividends are payments made to investors representing a portion of the
firms earnings. If earnings are paid out in the form of dividends,
and the fund manager does not need them to meet his clients income
needs, then he has the problem of re-investing them to achieve the same
rate of returns. In addition, the fund maybe a subject to income tax.
It is for this reason and due to the increasing requirement for investment
in technology, that there is an increasing trend towards the non-payment
Whether interested in deriving good returns from cash flow (in the form
of dividend income) or stock price appreciation (through company growth),
a major input to an equity analyst security selection process will be
corporate earnings which are the post tax profit for the period. These
earnings are derived from the companys profit and loss account
cost of sales = gross profit
Gross profit distribution cost administration cost = trading
Trading profit + other incomes interest payable = pre-tax profit.
Pre-Tax profit tax payable = post tax profit.
This type of breakdown
is useful for analysts, since they can more accurately attribute changes
in the stock price. Given this importance of earnings to the price of
security, they are the subject of detailed study by analysts who will
prepare estimate of corporate earnings going out several years into
There is a significant amount of administrative work that must be carried
out by the fund manager and his assistants to ensure the smooth running
and full investment of the fund. Current holdings within the fund will,
from time to time, generate dividend payments, which need to be re-invested.
This is important since fund managers are generally measured against
total return indices, which assume that dividends are reinvested in
the market. In addition, valuable rights issues and other corporate
actions may occur, which require the fund managers attention.
Initial Public Offerings may also be offered to the fund manager, which
need to be properly administered to meet with various compliance rules.
When carrying out orders on behalf of the client, the fund managers
must ensure that all regulatory checks are carried out on a pre-trade
basis. Also checked out on a pre trade basis are any client specific
restrictions, such as those preventing the fund manager from investing
in firms involved in unethical businesses such as tobacco production
or weapons manufacture? In addition, the fund manager must on behalf
of himself or his firm and that all clients are treated equally. From
a post trade perspective, the fund manager must comply with the requirements
for corporate ownership reporting as specified in the companies act.
Most funds apart from pension funds are subject to taxation.
A fund manager must keep the implications of his clients tax position
in mind when making investment decisions and also at year end. One way
to mitigate this liability is to bed and breakfast a stock building
up a large capital gain by selling it on the last day of the at ax year
and buying it back on the first day of the next. In this way the capital
gain is spread over a number of tax years.