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Fund sectors: can they help you build a portfolio?

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Written by: Paloma Kubiak
19/05/2016
A host of big-name funds, including the Invesco Perpetual income range, have been kicked out of the UK Equity Income sector recently after missing targets. Here, we go back to basics and explain what fund sectors are, and if and how they can help investors.

What are fund sectors?

Picking a fund can be a difficult task as there are thousands to choose from. Fund sectors were designed to make the choice easier for consumers and their advisers.

Each sector contains funds with similar strategies so in theory investors should be able to compare the performance of similar funds.

The sectors were created by the Investment Association (formerly Investment Management Association), the trade body for the UK’s fund management industry. There are around 40 sectors divided into four groups, each with a different investment focus: Growth, Income, Capital Protection and Specialist.

Each sector has a prescribed definition with a strict set of criteria. For example, the IA UK All Companies sector includes funds which invest at least 80% of their assets in UK equities, which have a primary objective of achieving capital growth.

If a fund doesn’t invest according to the sector’s parameters it may be moved (see below for more on this).

While the IA provides a definition for each sector, there are some broader ‘catch all’ sectors for funds that don’t fit neatly into their criteria, such as ‘Specialist’ where you’ll find biotech funds and natural resources funds among others.

Rob Morgan, pensions and investment analyst at Charles Stanley Direct, says the sectors generally only apply to funds domiciled in the UK, so most offshore funds, including those based in Dublin have a different set of sectors, though they are broadly similar.

Below is a table showing how fund sectors are mapped out:

YM FundSectorsTable

What’s the purpose of fund sectors?

Grouping together funds with similar strategies should in theory enable investors to assess performance more accurately.

Colin Low, managing director of independent financial firm Kingsfleet Wealth, uses the analogy of the small car market where buyers want to compare the performance of a Polo with say a Fiesta.

“They’re all in the same class but you can compare them in terms of speed, economy and different strengths at different times,” he says.

Morgan says categorising investments into sectors allows investors to more easily navigate the huge universe of funds, to identify those that might meet their needs and compare them with each other in terms of performance and charges.

“Comparing the fund with its sector in terms of performance can very broadly give some idea of how well a fund has done relative to its peers. Many funds also compare themselves to the sector as a benchmark.”

He says that funds in the same sector can also share some common risks, for example a fund investing in emerging markets can be subject to currency risk – i.e. that the emerging market currency weakens against sterling, potentially reducing returns – or heightened volatility and political risk.

Is performance the only factor to consider when picking a fund?

While there are certainly benefits for investors in drawing comparisons between funds in a sector, there are also some limitations.

Morgan says: “Funds within all sectors can vary significantly. For instance, in the IA Property sector there are funds investing in physical bricks and mortar properties and others investing in property equities. These two areas have completely different performance and risk characteristics so grouping them in one sector is arguably not particularly useful.”

He adds there may be a more appropriate benchmark for a given fund such as a market index like the FTSE All-Share, which tends to be used by industry professionals.

Investors should always read the fund’s Key Investor Information Document (KIID) before investing, which provides essential information and key facts about a fund, including its objective and investment policy.

It also helps to look at how a fund has performed in different market conditions. Generally, superior performance generated in both up and down markets is a sign of a good manager.

Morgan says you should also look out for where passive funds (i.e. trackers) sit in the performance tables within a sector.

“If they are near the top active managers have had a tough time beating the index over that period, perhaps because larger companies have outperformed. This may help shape your decision of whether to use an active or a passive fund for exposure to that area.”

For Low, it’s also important for investors to have a diversified portfolio “a bit like the ingredients of a cake” so you shouldn’t look at the sector by itself as you need a combination of assets.

He sums this up in the analogy: “You have your boring ingredients such as flour, but you make the cake interesting by adding chocolate, so when you’re creating a portfolio, you may have assets and gilts in the background, while overseas funds make up the interesting part of your holdings.”

He adds that while some sectors may be doing well today, next month it could be a disaster for the investor so “if you get the right individual ingredients, then you’ll get a lovely cake at the end of it.”

What do fund groups think of sectors?

The Evenlode Income fund is set to exit the IA UK Equity Income sector and move to the IA UK All Companies sector on 1 June.

It is the latest in a string of top performing funds, including the Invesco Perpetual income range, formerly run by Neil Woodford, and the Schroder Income fund, to be kicked out of the IA UK Equity Income sector after failing to meet the criteria.

Its manager, Hugh Yarrow said the “arbitrary” Equity Income sector must evolve.

He says: “The move is purely driven by the fund narrowly failing a somewhat arbitrary sector classification definition. At year end in February, its average yield was 3.7%. It needed to be 3.8% to meet sector requirements.”

David Holloway, marketing director for Rathbone Unit Trust Management, which has also seen its income fund kicked out of the IA UK Equity Income sector, says the definitions were set up some time ago so could be seen to be “potentially outdated”, especially in the current environment where dividends and income is much harder to find.

The IA has launched a consultation on the sector classifications and the deadline for submissions is this Friday.

An IA spokesperson adds that it’s unable to comment on the remarks made above during the consultation process but within the consultation document, it states: “Consideration needs to be given to whether the current yield requirement is fit for purpose. It is the committee’s longstanding view that the sector should have a clearly measurable target to make sure that only true equity income funds are able to be presented within it.

“It must be credible, and it must be a useful resource for investors considering which fund to buy.”

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