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The winning formula


In a year when a global pandemic, recession and record-low interest rates took centre stage, a growing number of specialist managers, including many high-profile names, failed to beat the market last financial year. Yet with market dispersion continuing to grow, active management has never been more valuable.

The first quarter of 2020 saw an unprecedented market sell-off in response to COVID-19. Advisers who chose the best-performing funds were richly rewarded with those managers delivering double-digit returns, but the vast number of funds produced returns that were less than flattering, and quite frankly could have been delivered by an index fund.

So, what happens when a fund consistently underperforms the market? Should you persevere or sell-out? Manager underperformance not only reflects poorly on the adviser, it completely undermines the justification for charging fees on that fund. In this article, we will highlight ten “safety checks” to use when selecting a managed fund.

  • Check 1 – Is it a growth or value fund?

    On average, “value” funds haven’t made sense for quite some time. The style has suffered a dreadful stretch of performance since the 2008 financial crisis, with value-oriented managers underperforming the market year after year. But that’s not to say value investing is dead, it’s just lost its value.

    Experts say tech dominance, together with record-low interest rates and a decade-long bull run, are the main reasons why value investing hasn’t worked. Fund managers that stayed clear of “growth” stocks will have missed out on this once-in-a lifetime tech bonanza. They will have also underperformed the market by a long shot.

    The divergence in Australian share fund returns in 2020 has been huge, with the difference between the best and worst as much as 30% in some cases. Value funds can offer safety and performance during an economic downturn but with the Australia recession largely over, do growth funds remain the best option? Either way, it’s crucial to know what you are holding and that it is true-to-label. Be wary if a “value” manager is holding tech stocks or a “growth” manager is holding oil stocks.

    Check 2 – What is their active share?

    If you are going to make the decision to employ an “active” manager and expose your clients to the additional management costs, then you want to ensure the fund’s portfolio managers are doing what they say. Active share is a measure of the fund’s difference to its underlying benchmark. For instance, an active share of 80% for an Australian equity fund suggests that 80% of the fund’s holdings are different to the S&P/ASX200 index, in weightings and holdings.

    Check 3 – What is its “wow” factor?

    It should be easy to distinguish a fund manager’s “wow” factor and what sets it apart from the herd. Do they have a special skill in selecting investments in one particular area i.e. infrastructure or private equity? Does it analyse and process data in a unique way, for example, a quantitative fund? The aim is to identify the type of fund required and make certain it matches with the fund manager’s “wow” factor. In an uncertain environment, having a sustainable and competitive edge is more important than ever. More often than not, a successful Australian equities-based fund manager will find itself launching a global strategy fund, with little experience or resources in global markets: this is a very difficult proposition.

    Check 4 – Can you sell out in a Black Swan event?

    Investors who held managed funds during the GFC will remember the big freeze. Australian savings were frozen in mortgage and property funds, with more than $5 billion locked-up in investments. This often occurs to protect the interests of all members from assets being sold at below market value during a market collapse. A frozen fund isn’t a bad thing, and does not mean that the value of investment has fallen. This is increasingly important following the flood of alternative investment strategies into the market, but is of no concern for traditional domestic and global equity funds.

    Check 5 – Who is steering the ship?

    Almost every investment fund will have a highly experienced portfolio manager(s) or an investment manager behind the buying and selling decisions that make or break the fund. That means, as a financial adviser, it is important to know who is steering the ship and what their track record looks like. The difference between a good fund manager and a mediocre one can be huge. In the recent climate, it boiled down to an ability to identify companies with future earnings growth and a willingness to ride out volatility when it erupted. Ultimately, you need to ‘eyeball’ management, just as your fund managers would seek to meet the leaders of the companies in which they are investing.

    Check 6 – Return, return, return

    It’s a well-known fact that, as the disclaimers put it, “past performance is no guarantee of future results.” In other words, don’t assume an investment will produce the same results simply because it has done well in the past. As we’ve seen this year, many funds that had a hitherto stellar return track record underperformed the market index by a long shot. Historical performance is simply an indicator of the potential for future performance.

    A better way to assess performance is by comparing returns to a suitable benchmark and then measure how the fund has performed relative to that benchmark in different conditions. Ideally performance should be measured over a reasonable period such as five years, and importantly, how the fund has performed in a down market. This will give you an indication on how conservative or aggressive the strategy is. For example, a small-cap fund may perform extraordinarily well during a bull market; but in a market downturn it can severely underperform the market.

    7 – Understanding the fund’s volatility

    High returns are great, but as we have seen this year, generating high returns with high volatility can be a recipe for disaster. Volatility is the range of investment returns, or the standard deviation. Returns from volatile investments can be erratic and a lot less stable.

    Put simply, if the price of a fund moves rapidly over short period, it has high volatility, and the range of returns is wide. High potential returns, but higher risk. The holy grail is to look for a fund that comes with stable (or target) returns with the lowest risk of its peer funds in the particular investment strategy.

    Similarly to volatility, portfolio turnover is another key measure for consideration. As the name suggests, turnover measures the portion of the portfolio that is bought and sold in any given year. Research has shown that compounding of returns over the long term is the most powerful investment strategy, with regular stock-trading doing little but increasing the transaction costs. For long-term equity strategies, turnover is generally less than 100%, with those above this much more active and more akin to trading. 

    8 – Performance attribution

    Performance attribution is a process used to evaluate a portfolio manager’s performance i.e. return versus an appropriate benchmark. It determines how asset allocation and selection of securities has affected the portfolio’s performance when compared to a benchmark. The two types of performance attribution are asset allocation and stock selection. In short, if the attribution number is positive, then the portfolio manager has contributed positively to the portfolio’s overall return, and vice versa.

    Ishan Dan

    Ishan is an experienced journalist covering The Inside Investor and The Insider Adviser publications.

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