Jonathan Ramsay discusses whether knowing if the times suit a fund manager is critical to determining when they will outperform.
The vexed issue of past performance has huge implications for the advice industry and it’s not surprising that recent analysis and comment from van Eyk around performance persistency has attracted considerable interest and many follow-up questions.
Is there any evidence that the fund managers with the most impressive track records will continue to outperform?
The evidence suggests otherwise.
Yes, we have the industry mantra that ‘past performance is not a reliable indicator of future performance’, but it only goes so far and is so ubiquitous no-one thinks about it anymore.
Chart 1 shows the correlation between excess returns in one three-year period and the following three years amongst the 52 “core, large cap” managers active in Australia in the last 10 years.
It makes a fairly straightforward point – most of the time, buying into yesterday’s winner is not a successful strategy, except occasionally in a trending market, when a particular theme dominates for a period.
In 75 of the months since the year 2000 the correlation between excess returns in the two three-year periods was negative.
This compares to 39 months where past performance did indeed seem to be associated with future outperformance.
Of course, hope springs eternal and a strong track-record still carries weight; ask anyone in sales.
Like gambling addicts or the 90 per cent of drivers who reckon they are better than average, we all think we are different and that we can pick the subset of managers that have outperformed and will continue to do so.
To put that in context, the performance-chasing investor of three years ago would have had only a one-in-five chance of picking an outperformer from the line-up of contemporary manager stars, compared to a one-in-two chance for the contrarian investor who instead chose a manager from the past-performance dustbin of that time.
Perhaps three years is too artificial a time horizon, one which is transcended by the very best managers.
Do investors just need to be more patient as these three-year swings and roundabouts are just a cost of doing business in volatile, cyclical markets?
Chart 2 shows the total value added over a fund’s lifetime by the subset of funds with a track record of 10 years or more (to account for cyclical factors).
So are there any common traits amongst those top-performing managers at the right-hand side of the distribution in Chart 2?
It turns out that all bar one of the seven managers that have outperformed by around 1 per cent per annum or more during the life of the fund got there by producing stints of very strong outperformance rather than grinding out gains of 1 per cent per annum consistently.
In fact nine out of 10 managers making up the right hand side of the above distribution (the strong outperformers) were also part of the subset of managers that have at some point outperformed by 5 per cent or more per annum for a three-year stretch.
They ended up on the right hand side because they managed to hold onto those gains when their style or process was out of favour – even if that stellar outperformance deserted them for long periods, they performed in line with the market rather than giving it all back again.
The implication is that for managers to add value they have to take some risk at some point in order to perform well, and perhaps take some risk off the table when their investment style is not suited to the prevailing market environment.
Can we predict which managers will “catch their market wave” ahead of time? Here are a few rules of thumb that can help:
- If you are thinking about using past performance as a guide – don’t! If anything, underperforming funds have a better chance of outperforming in the future, but that’s not a particularly good criterion either.
- Rather, you need to focus on the manager’s investment fundamentals. The strengths our rating team look for are the best people, a logical and differentiated investment process, a well-run business and most importantly of all, some evidence of an “edge” in the market in terms of information or analytical skills.
Bear in mind that these days funds management firms are very good at marketing and that is why we tend to employ analysts with experience actually managing money – poachers turned game keepers. - Then, search for a manager who looks as if he or she might be about to catch that wave due to the interaction of their investment process with the stock-picking environment or the overall macro positioning that is the usual outcome of the process.
Sometimes this is accompanied with a sense of frustration on the part of the manager that the market has been missing something. - Finally, choose a manager who is willing and able to take on considerable investment risk when conditions warrant. Some managers are less nimble than others (sometimes because of their size) or are restricted by their investment mandate.
Step three is where much of the nuance and skill is required. It could very well involve choosing a manager who has done well, but in that case the investor should be clear that the selection is made on the basis of the prevailing market conditions continuing.
Our analysis suggests, however, that manager outperformance is somewhat episodic and doesn’t last forever.
One good pointer to which managers will perform well is valuation. At van Eyk we took a view two years ago that quality stocks were somewhat undervalued and, especially in the international context, would benefit from the expected volatile and range-bound market conditions.
This was part of the reason why international equity managers like Walter Scott and IFP received high ratings.
It’s probably too early to make a definitive call but valuations for some of those quality stocks may be looking a little stretched now and there are certainly a few frustrated managers with overweight positions in cyclical stocks.
Finally, remember that in financial markets investors get rewarded for taking a risk that others don’t want to at that particular point in time, so making this type of call about the future prospects for a manager will rarely feel very comfortable at the time.
Jonathan Ramsay is the head of strategic research at van Eyk Research.
