Investors are often too optimistic (or misinformed) about the probability that a fund will continue to deliver market-beating returns, an independent financial adviser says.
About 80 percent of money invested in South African broad-based equity funds is in 20 large, actively managed funds, Daniel Wessels, of advisory firm Martin Eksteen Jordaan Wessels, says. Success has bred success, with more investors wanting “to share the ‘magic touch’ of these funds”, he says, but you should be realistic about whether they will continue to deliver good returns.
There is at least R1.5 billion invested in each of the 20 funds, Wessels says. As a group, they have out-performed the other funds in the domestic equity general, value and growth sub-categories over both the short and the long term, which explains their popularity, he says.
But Wessels points out that none of them has out-performed the usual equity benchmarks, the FTSE/JSE All Share index (Alsi) and the Shareholder Weighted All Share index (Swix), over the past eight years. However, the funds have out-performed the Alsi over periods from nine to 12 years, he says.
Did the 20 funds become top performers because their managers were skilful or were their managers simply lucky?
Wessels says it appears that some managers exhibit some skills, because they have beaten the odds of their out-performing the equity market based purely on luck alone.
He came to this conclusion after considering some statistical probabilities and comparing these with the actual performance records of the top 20 funds.
Over the nine-year period to the end of June, for example, he found that, statistically, six of the 20 largest equity funds should out-perform the Swix four times and two funds should out-perform the Swix twice.
In reality, funds out-performed the market more times than could be explained by chance, Wessels says.
He also found some of the 20 largest equity funds had more successive years or streaks in which they out-performed the market than statistical probability indicated they should over the nine years.
For example, the probability is that four funds out of 20 will out-perform the market for three years in a row over nine years, but in fact seven funds did.
Probabilities show that only one fund in 20 should out-perform the market for five years in a row over a nine-year period, but two funds did.
Despite some evidence of manager skill, Wessels says investment success is a combination of luck and skill, with luck playing the dominant role, especially when managers have more or less the same level of skill – and skills tend to converge in a competitive environment such as investment management.
In addition, social influences and imitation (investors following what other investors are doing) cause investors to favour a manager who is not necessarily the most skilled, he says.
Besides needing luck on their side, the managers of the 20 largest funds face other stumbling blocks that could prevent their funds from repeating their good performance over the next 10 years, Wessels says. These stumbling blocks include the relatively large size of the funds, the inherently low probability of their out-performing their benchmarks and erratic investor behaviour.
Wessels says there is insufficient evidence to show that large funds can maintain their out-performance over the long term. For example, of the 10 top-performing funds over the past decade, only three were among the largest funds 10 years ago, while the other seven funds were relatively small funds at the time.
Likewise, only one of the 10 top-performing funds over the past five years was considered to be a large fund five years ago, while the other nine funds were relatively small.
Continuous inflows of investor money may result in a fund having to adopt a portfolio positioning that the manager does not necessarily prefer, Wessels says. At a certain point, the size of a portfolio will make it not much different from the index, he says.
There is also a relatively low probability that a fund will continue to out-perform over the long term, Wessels says.
The performance figures to June 30 appear to show that more than half of all domestic equity funds out-performed the market over the past 10 years, but these figures do not include the data of funds that have ceased to exist and they therefore mask the real experiences of investors, Wessels says. Once this survivorship bias is removed, the percentage of equity funds that have out-performed the market over the past 10 years drops from 50 percent to 31 percent, he says.
Similarly, whereas the performance data for the past 15 years show that 17 percent of funds have beaten the market, the real success rate (once survivorship bias is removed) is as low as 12 percent, he says.
Over the past 20 years, 38 percent of funds appear to have beaten the market, but once the survivorship bias is removed, only 18 percent of all the funds that existed over the period can claim this success, Wessels says.
Many of the 20 largest broad-based equity funds have a value-oriented investment style, and, Wessels says, value funds have undoubtedly been the best-performing domestic equity funds over the past decade.
Value-style funds have, on average, produced an annual return of more than 20 percent over the past 10 years.
The good performance of value funds over the past decade does not mean that the value style will always out-perform, Wessels says. In the 1990s, value-style investing did not fare well, because investors favoured companies with high expected earnings growth, Wessels says.
No particular style of investment – nor, for that matter, any fund manager – can perform well all the time, he says.
Your behaviour as an investor is another problem of which you should take note. Investors tend to flock to funds that are performing well, Wessels says.
“This type of behaviour causes regular switching of investment funds to the latest hot performers as if the relative out-performance of a manager will continue forever.
“Investors may falsely believe that a fund’s performance over a certain time period is equal to what he or she earned on his or her investment,” Wessels says.
But this is not the case, because the investor’s investment period may be shorter than the term quoted in the performance figures, or the investor may have made additional investments or withdrawals during the investment term.
The fund’s reported return may therefore differ from an investor’s return.
For example, value-style funds have a reported average return of more than 20 percent a year over the past decade, whereas investors in these funds received an average return of only 13 percent a year over the same period.
If you do not understand a manager’s investment process (and therefore when and why it is likely that it will under- perform the market), you may be tempted to switch to a manager that is perhaps performing better than average at the time.
Switching funds simply because you do not understand your manager’s investment process is likely to result in your earning much lower returns than you would have received if you had invested in one fund and stayed in it (a buy-and-hold strategy), Wessels says.
These factors indicate that the likelihood of a large, successful fund manager remaining a top performer over the long term is not particularly high, he says.
You may take comfort from the fact that you are invested with a large, respected and trusted management company, even if your future returns will not be among the best, but trying to identify the next set of winners is guess work, Wessels says.
An alternative is to invest in an index or an enhanced index fund, such as exchange traded fund, which can be up to 50 percent cheaper than an actively managed fund with a good chance of delivering an after-cost return above that of the typical actively managed fund, he says.
However, Delphine Govender, a director and portfolio manager at Allan Gray, says Allan Gray’s track record indicates that it should be one of the managers that will continue, on average, to out-perform the market.
She says it is important for a manager to have a consistent process it can use to transparently demonstrate that its investment decisions resulted in its out-performance over time.
Govender says Allan Gray has managed the size of the assets it manages relative to the investable universe on the JSE and believes it still has headroom to find value and to be contrarian.
She says an inability to stick to an investment process during periods of under-performance presents a greater stumbling block to continued good performance, and managers in listed groups that need to report to shareholders are typically put under pressure to change their processes when times are bad.