1. The apparition

Many nightmarish investments I have witnessed have stemmed from supposedly “hot” sectors that subsequently failed to live up to the hype. Namely the apparition of a good investment that turns out to be too good to be true.

Many investors will recall technology or internet funds from the late nineties with horror. Although initially highly successful, a rash of “me-too” fund launches and sky-high valuations should been enough to scare people away.  Sadly, many ordinary investors were too late to the dotcom party; the area peaked at the turn of the millennium and some saw their capital decimated.

The lesson: a sector that proclaims to be “the next big thing” is probably as big a red flag as you can get that your investment will come back to haunt you. The internet mania (eventually) brought a few success stories such as Amazon and eBay, but most companies turned out to be tricks rather than treats.

2. The high yield zombie

Investors are naturally attracted to investments producing a high level of income. However, it is also a warning sign. There is likely to be a very good reason why an investment yields so much. For equities, is the dividend is likely to be cut? For bonds, higher yield means higher risk – there is more chance of default and capital loss.

Such “value traps” can become a dead men walking in your portfolio, dragging down your returns instead of boosting your income. It is therefore well worth doing some research to ascertain the sustainability of the yield.

One test is to what extent the income paid by the asset is covered by physical cash flow? For example, if income paid is from capital, from raising debt, or from an accounting profit not backed up by actual cash, then the level of income paid could be unsustainable. This is particularly pertinent for individual shareholdings, where this assessment is referred to as “dividend cover”. If cash flow is robust and higher than the dividends paid by the company, then the yield has a better chance of being sustainable.

3. The skeleton in the closet

In contrast to “passive” fund or trackers, which simply aim to replicate the performance of an index, “active” funds employ fund managers to try and select the best performing investments. We believe there are merits to both strategies: a passive route usually means keeping costs low, while active funds have the potential to outperform over the longer term, even though they are more expensive.

Yet funds masquerading as active but providing passive-like performance – the so-called “closet trackers” – should definitely be avoided. If you pay for active performance that is what you should get. These funds may not be readily distinguishable, but if performance is consistently similar to the market, or slightly below, and the top 10 holdings bear remarkable resemblance to the largest components of the market, then there is a chance you have a closet tracker lurking in your portfolio.

Rob Morgan is pensions & investment analyst at Charles Stanley Direct

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