The conventional wisdom in some quarters is that fund managers underperform. But does this stand up to analysis? “Conventional wisdom is the body of ideas or explanations generally accepted as true by the public or by experts in a field. Such ideas or explanations, though widely held, are unexamined,” according to Wikipedia.
So, let’s examine. The dominant investment type is sector-based relative return. I focus on this area and Australian equities in particular.
Relative-return equity managers set an investment objective requiring them to outperform a nominated benchmark over time. This has nothing to do with so-called business risk. It is simply a reflection of the fact many investors – institutional or retail – do not expect that their investment manager has perfect market knowledge enabling them to consistently position in only the best performing stocks.
So, knowing that the market will appreciate over the long term, these investors ask their managers to track the general direction and then add additional value using their expertise in the context of an agreed risk budget.
It is important to understand your manager’s risk budget. If, over time, your manager either fails to “spend” this budget or spends it without creating an excess return, it likely indicates that she lacks the requisite skill and confidence.
No immunity to struggle
No investment style is designed to perform equally well in all conceivable investment conditions. There will be periods (sometimes extended) when a style will struggle to add consistent value, so any effective assessment of manager skill must take place over the long term.
There are exceptional periods such as the second half of 2007 through to the present when, typically, a form of global shock makes the job of consistent outperformance especially hard. This does not mean that relative-return management doesn’t work. It just means that the payoff will take longer.
Taking all of this into account, it is generally regarded as fair to assess manager skill over rolling five to 10-year periods.
By definition, if the relative-return manager beats the stated benchmark over the long term, then she will have outperformed. The reverse also applies.
How much should the “beat” be? This is where it gets complicated – it depends on the risk budget. Nevertheless, if the manager can generate an excess return of 2.5 per cent with a tracking error of 2.5 per cent, giving an information ratio of one (2.5 per cent/2.5 per cent), it is generally regarded as an excellent result.
I would recommend that a diversified portfolio of stocks with a sensible risk budget that can beat the market by 200 to 300 basis points over a long time frame is highly attractive and not easily replicated.
If I invest $100,000 at the beginning of a decade and receive a market return of 9 per cent per year, I finish the decade with $236,736. If, rather, I receive a return of 11.5 per cent (the market plus 2.5 per cent per year) I finish the decade with $296,994.
The point also remains intact on a net basis. For Australian equity distributing trusts, the average fee is around 0.85 per cent and many investors will also receive a rebate.
If the manager beats its benchmark by 250 basis points per year over time, then the investor is ahead by 1.65 per cent per year. That’s both very valuable and extremely hard to achieve in a do-it-yourself environment.
Using Mercer data, we have analysed five-year rolling excess returns over a 15-year period. This test period is arguably harsh given that it includes the global financial crisis.
Doing what they said they were going to do
There are a number of managers with a proven track record of meeting stated investment objectives. That is, doing what they said they were going to do. This is represented by the top quartile of managers (blue line).
Achieving this is not easy as shown by the number of managers who do less well, as represented by the median manager (purple line).
The data is indicative of a somewhat scarce commodity – the ability to consistently outperform the market by an average margin of 200 to 300 basis points over the long term.
And that is why we have a robust research-house and asset-consulting sector designed to ensure that clients are made aware of those managers experiencing (for some reason) decline and those who are not.
Why then is the conventional wisdom in some quarters that the funds management sector has let investors down? Don’t give up the fight! The good managers are there and investors should remain alert to their presence.
I have also heard it mentioned that equity managers “hold back” income. This is simply untrue. Yes, the level of the underlying company dividends and ultimately the distribution may vary with the manager’s style and portfolio composition, but it is tax avoidance (that is, illegal) for the unit trust not to distribute all dividends and all franking without paying fund earnings tax.
So, if the underlying dividend yield at a point in time is 5 per cent in a diversified active large-cap portfolio, then the unit holder will notionally receive around 5 per cent gross and all of the associated franking.
If during the same period the manager turns over some stock and this results in a realised capital gain without corresponding losses, then this too must be distributed to the unit holder. If the unit holder doesn’t want this income in the physical sense then, easy, they re-invest it.
Yes there are tax implications, but how important are these given that 70 per cent of our investors are in a 15 per cent or 0 per cent tax-paid environment?
Mark Knight is head of retail business at Ausbil Dexia Limited