The fact there are hundreds of professionally managed investment funds in a small economy such as Australia’s is likely a side-effect of our compulsory super system, which has produced – at a grand total of $1.6 trillion in assets – one of the largest retirement savings pools in the world, and among the top three when taken as a proportion of GDP.
With so much money looking for a home, it’s not surprising that professional fund managers have proliferated – and profited.
When it comes to managed funds “there’s an abundance of choice”, says van Eyk senior investment analyst Varun Venkatraman.
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“In fact, there’s too many to choose from; they all have that shiny marketing piece, but how do you decide?”
Of course, Venkatraman is paid to scour the industry for the best funds, so his question is rhetorical.
Many of us would start with performance – after all, isn’t making money what we are all trying to do?
“It’s a certainly a good place to start, but not a good place to finish,” says Chris Douglas, co-head of fund research at Morningstar Australia.
So it’s fair to say that if an active manager (one that is trying to beat, rather than match, the market) has a 10-year history of beating its benchmark, that really is a great start.
But as Douglas says, it’s not the final word. In conjunction with our research partners, Morningstar, we have whittled down the universe of funds to a still-expansive list of 100 funds, the bulk of which are actively managed (the exception are the exchange-traded funds on page 33), and which meet a range of criteria based on both the tangible and less tangible elements (see “How we picked our top 100 funds”, also on page 33).
Many, if not most, of us tend to gravitate towards funds which are at the top of the performance tables based on one- or two-year track records.
This habit, known as “chasing performance”, can be particularly damaging to your bottom line.
This was highlighted recently by one of the country’s most successful fund managers, Platinum Asset Management’s Kerr Neilson, when he told an investment conference audience that an initial investment placed in his flagship International Fund at its launch in 1995 would now be worth 9.5 times what it was then.
But over that period, unit holders have shown a tendency to jump into Neilson’s fund when times are great, and bail when the going gets tough.
As a result of this all-too familiar psychological foible, Neilson estimated the average investor only made three-and-a-half times their money, instead of almost a tenfold increase in their initial capital.
Indeed, the adage of “past performance is no guarantee of future performance” should be updated to “past performance is a likely indicator of future underperformance”.
According to research conducted by van Eyk on what is called “persistency” (see “Feather duster to rooster”, above, selecting a manager based on the sole criterion of who has the hottest record over the past three years yields only a one-in-five chance of picking an outperformer over the coming three years. In contrast, selecting your fund from a roster of laggards would give you a one-in-two chance.
Those kind of insights suggest that, just as in stock picking, investors would be well served adopting a contrarian approach to selecting a fund.
“If somebody is losing money consistently, then there’s something wrong with that,” says Venkatraman.
“But if you have an outstanding fund manager with a tried and tested performance who’s been around for a long time and they’ve had a bad year or two, that’s essentially a good time to be putting money in.”
Intellectually that may all make sense, but as we’ve seen, emotionally we struggle to take a position that involves taking a loss now for bigger gains later. Still, it’s a lesson every investor needs to learn.
Go for quality
The bottom line is that it’s inevitable even the best money manager will at some time lag the broader market, whether it be shares or fixed interest.
“There will be periods where they underperform, that’s just the nature of the beast,” says Douglas.
“No one is perfect, except for Bernie Madoff – and we all know the story there.”
Which explains why professionals such as Douglas and Venkatraman – along with dozens, perhaps hundreds, of others like them – spend so much time trying to understand the ins and outs of a manager’s investment process and philosophy.
“One of the things we try to do is try to understand a fund’s performance characteristics and try to understand how it will perform in different markets,” explains Douglas. And it’s what you should be doing as well.
A good start is to look at the turnover rate of a portfolio. It shows you the percentage of a fund’s holdings that have changed over the past year, and it also gives you an idea of how long a manager holds on to a stock.
The maths is straightforward. A turnover rate of 25 per cent implies the manager holds on to a fund for an average of four years, and so forth.
Once you have that number at hand, you can match that up with what the manager is saying. If they say they invest on a three-year basis, but report a 100 per cent turnover, then you need to ask some questions.
It may be the case that a fundie has been investing a significant long-term theme that has come to fruition, resulting in a lot of stocks hitting their price targets in a short period of time. Nothing wrong with that, but don’t just assume that’s the case.
“When it comes to assessing the quality of a manager, we look at the five ‘Ps’,” explains Douglas. “People, process, parent, performance and price” – the last being fees.
“We try to understand the investment psyche of the portfolio managers,” he explains. “Also what their experience and backgrounds are like, and how decisions get made.”
The investment process is, of course key. So when selecting a fund, consider whether that process is time-tested: has it worked in different market cycles? How consistent has it been?
If you are going to hand over your hard-earned cash, you absolutely need to have faith in that manager’s abilities.
Venkatraman says they should have a good, concise strategy they can relate to you clearly, along with a description of how they can implement it.
He reckons he can tell in “under one minute” whether a fund manager is up to scratch.
“If a chief portfolio manager cannot say exactly what his edge is over the market then clearly he hasn’t identified what his niche is.
“And if you can’t find some edge, then [trying to beat the market] is really a pretty futile effort.”
On that score, Venkatraman reckons investors are better off paying fees to managers who are able to take risks and back their own judgement, rather than holding a portfolio that is barely indistinguishable from their benchmark.
“What you have are a lot of fund managers who are holding a portfolio that is barely any different from the index,” he says. “Sure, they are outperforming a little, but once you take fees out there is nothing left.”
He likes high-conviction managers, such as Gian Pandit at AMP Capital, Paul Skamvougeras at Perpetual, Simon Marais at Allan Gray, and, a relatively new name, activist investor Gabriel Radzyminski at Sandon Capital.
Something you shouldn’t accept from your manager is secrecy. Sure, a professional stock picker doesn’t want to disclose every trade and trade secret – it might get in the way of them doing their job – but they should keep you up to date with what they are doing with your money.
“They should be providing quarterly newsletters, or regular articles and insights into what they are doing,” says Douglas.
This is particularly important when a fund is going through a rough patch. The fund’s managers should be letting investors know why the performance hasn’t been as expected, and what they’re doing about it, along with information on whether they are making changes and if they are comfortable with the portfolio, he adds.
One major area where the industry has generally let down its clients is in the reporting of performance figures. How much risk a manager is taking on to generate a certain level of return is a crucial piece of information that is sadly lacking in most fund performance reports.
If two managers are generating equally good returns, but the first is doing so by taking much riskier positions, then you would naturally prefer the second. It would also indicate that the second manager is likely a more skilled investor than the other.
Figures such as the “Sharpe ratio”, otherwise known as the reward-to-variability ratio, and the “information ratio” offer a way to measure returns on a risk-adjusted basis.
The latter, for example, standardises all manager excess returns above the benchmark by the amount of deviation they take from the index.
A higher ratio means a manager can achieve better returns from additional risk than a manager with a lower score.
The Sharpe ratio tries to achieve a similar objective. By subtracting the fund’s performance against a risk-free rate (such as the 10-year bond yield) and then dividing by the volatility of the portfolio returns, this ratio tells you whether a manager’s excess returns are due to smart investment decisions or a result of taking on extra risk. As a rule of thumb, a Sharpe ratio of 1 or better is considered good, above 2 very good, and 3 or more excellent.
Without the underlying data, it’s not straightforward to calculate these numbers yourself. But there is absolutely no reason why any halfway-decent fund manager would not be able to do it. So why don’t they? Because more investors don’t ask for it, probably. Not to mention the fact they may not be comfortable with the extra scrutiny.
“I think as people start demanding accountability and transparency they should start delivering those [risk-adjusted] figures, and that will be better for the industry as a whole,” says Venkatraman. “It will let people see, on a risk-adjusted basis, who’s capable and who’s not.”
Vote with your feet
Indeed, fund managers may have had it too easy for too long. Witness the growing number of disgruntled savers who, disappointed the high fees paid to professional stock pickers too often haven’t translated into high returns, have moved money to low-cost passively managed funds, or taken direct control of their retirement assets through a self-managed super fund.
Some of the country’s largest pension funds are bringing their investment expertise in-house. But as we’ve seen, there are professional investors who are worth the fees you pay them. And our top 100 funds is a great place to start. Happy hunting.
How we picked our top 100 funds
Funds have to be open to new investment.
Funds have to have investment minimums of less than $100,000. (Most are in the $5000 to $50,000 bracket.)
They must be more than $10 million in size.
Funds must have Morningstar analyst ratings of gold, silver, or bronze.
Funds must have Morningstar ratings of three, four, or five stars. These are funds that have produced reasonable to excellent short, medium, and long-term risk-adjusted returns relative to similar funds. The exchange-traded fund criteria are based on our analyst ratings, as the other managed fund criteria are not applicable for ETFs.