How to identify best funds in the business

Money Observer's 2016 fund awards are designed with two aims in mind: to recognise the achievements of top-performing actively managed funds; and to provide private investors with some confidence that the achievements of winning funds are repeatable.

We do this by assessing risk-adjusted returns as well as performance relative to a relevant peer group of funds, over several periods.

This means we are not recognising the very best-performing funds over three years in isolation; rather, the system identifies funds that deliver sector-beating returns without significant dips in performance compared to their peers.

Generally speaking that means fund managers, particularly those focused on equities, who are taking relatively less risk to generate decent investment returns.

Savers need to become investors

While this may not suit more adventurous investors who are prepared to stomach higher volatility in pursuit of their goals, lower volatility is something we think is desirable for Money Observer's core readership.

Why? Increasingly private investors, mainly via tax-advantaged wrappers such as ISAs and self-invested personal pensions, need to make their own investing decisions without relying on independent financial advice, which has become an expense many are unwilling to bear.

With returns on cash deposits continuing to fall, and with no indication that interest rates in the medium term will return to anything approaching the 5% level before the 2008 financial crisis (let alone the 7.8% average since 1971), it is clear that ISA savers need to become ISA investors if they are to meaningfully grow a nest egg.

We believe they can best achieve this by focusing on funds that have delivered decent returns without taking excessive risk (although risk-taking is an essential part of generating decent returns).

It is even more important for investors near or at retirement who want to generate income from their accumulated savings but take relatively little risk.

This year, we asked data provider FE Trustnet to assess only the most expensive widely available "clean" retail share class of investment funds that private investors can buy (the most expensive is used to provide a "worst-case scenario" of fund costs for investors), and to omit "legacy" share classes that include commissions payable to financial advisers.

Our award-winning funds are run by managers who invest in a fashion that tallies with our awards-filtering system, often guided by strict principles tried and tested over several years.

That is one of the reasons why 36 of the 42 award winners of 2015 made it through our quantitative performance filters this year too.

Our Roll of Honour shows that 32 of the 45 winning funds have already been accorded Rated Fund status for 2016. Moreover, 23 recipients of this year's accolades are Money Observer award winners from 2014 and 2015.

These facts are strong indications that, when properly assessed, past performance can be a valuable guide to the future.

Methodology

Contenders

Funds, including offshore-domiciled funds, must be members of an Investment Association (IA) sector. All charity, exempt, institutional and private funds are excluded, as are all passive index-tracking funds.

Each fund must have a minimum of £15 million of assets under management (AUM) as at 31 March 2016, and at least a three-year qualifying history (with no breaks in the history due to any material change in fund structure, objectives or governance).

Contenders for best smaller fund awards are those with AUM of £15 million to £150 million. Contenders for best larger fund awards are those with AUM of £150 million plus.

Relevant fund share classes for private investors

FE Trustnet has referenced the most relevant "clean" retail share class to measure performance. This will be the highest-charging unbundled (free of any rebates or intermediary commission) share class widely available.

This means we are assessing a more accurate representation of returns to private investors, because it only includes the fund manager's annual charges and not commission fees.

Quantitative methodology

The filtering process

The funds for the individual performance awards are filtered as follows:

The funds are ranked from best to worst on their risk-adjusted returns over three years to 31 March 2016 as defined by the Sharpe ratio.

This measure calculates the level of a fund's return over and above the return of a notional risk-free investment such as cash or government bonds. The difference in returns is then divided by the fund's standard deviation - its volatility, or risk measurement.

The higher the Sharpe ratio, the better: as the ratio increases, so does the risk-adjusted performance. In effect, when analysing similar investments, the one with the highest Sharpe has achieved more return while taking on no more risk than its fellows.

The three-year ranking is filtered to include only those funds which remained in one of the top three quartiles in their sector for each of the last three years, across the following measures:

- one-year risk-adjusted returns as per Sharpe ratio;

- one-year relative performance versus the fund's IA sector

This filters out any weak performance in terms of weak risk-adjusted returns or weak returns relative to the fund's sector (the two relative return measures). This process creates a shortlist of funds that meet the criteria defined above.

Ethical/Socially Responsible Investment awards

Using the same filtering process as above, contenders are derived from the following IA sectors:

- Equity: any equity-oriented sector

- Mixed asset: the three mixed investment sectors and flexible investment

- Bond: all sterling bond sectors

Absolute return funds

For the awards for absolute return funds, the following calculation applies:

Rolling returns of 12 months every month over the past three years, which gives 24 one-year periods. A calculation can then be made for all funds as to how often they have achieved a rolling 12-month positive return.

In addition, for some consistency with other individual fund awards, the three-year Sharpe ratio is also assessed.

Qualitative considerations

- Fund manager's tenure: we favour those with a history of at least three years managing the fund.

- The fund should be easily accessed by a wide spectrum of retail investors. This means "soft-closed" funds that could levy an initial fee are excluded.

- The fund's strategy should broadly tally with retail investors' expectations for the award category.

- Where a fund's three-year performance (after satisfying the filtering requirements) is significantly superior to another fund with a better three-year Sharpe ratio, we may favour the higher-performing fund if its Sharpe ratio is not significantly lower.

- Where a fund's size excludes it for "best smaller fund" consideration, we may exercise leeway if its size is just over the £150 million threshold and its absolute or risk-adjusted performance is significantly superior to a smaller fund.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.