Your thinking is flawed if you believe that you or your financial adviser can pick the top-performing fund manager and ensure your financial well-being.
Two speakers at a recent conference for financial planners attacked the notion that you can identify a top-performing manager who will always be at the top of the performance tables, or even that you should aim to do so.
Fund managers take risks to deliver returns, but different risks pay off at different times, and you would be better served having someone manage your exposure to what are known as “good risks”, which deliver returns, Roland Rousseau, the head of Barclays Risk Strategy Group, told the Financial Planning Institute’s recent Retirement and Investment Conference (see “Risks that deliver returns”, below).
The other speaker, Anne Cabot-Alletzhauser, who heads the Alexander Forbes Research Institute, says investors and their advisers pay a huge amount of attention to seeking a manager who can deliver a small amount of performance above that of another manager, when this makes only a tiny difference to your financial well-being. She says many other aspects of your financial life deserve to come before trying to identify a manager with skill.
Both she and Rousseau argued that identifying skill is a fruitless exercise (see “Don’t look for the hottest manager”, link below).
Rousseau says most people identify skill by considering whether managers have outperformed a benchmark, such as the FTSE/JSE All Share Index (Alsi), or have beaten their peers, but this is not the way to identify skill.
The FTSE/JSE Dividend Plus Index has outperformed the Alsi, as well as 75 percent of actively managed general equity funds, since its inception 12 years ago. But it doesn’t make sense to attribute skill to the index, Rousseau says.
The Chartered Financial Analysts’ (CFA) Institute, a global association of investment professionals, has defined investment skill as the ability to outperform the risks you have taken, rather than the ability to beat an index or peer group, he says.
Yet, Rousseau says, there is no survey available to individuals in South Africa that measures whether managers have outperformed the specific risks they have taken.
Rousseau says managers take risks greater than those inherent in the market in order to beat their benchmarks, and it can be good for you to be exposed to these risks to earn good returns. However, while managers pick shares they believe will outperform eventually, they can go through long periods of under-performance, during which you, as an investor, have to sit tight and wait until the market proves their investment strategy was right.
This is relevant now for South African investors who are invested with the many managers who actively take an exposure to shares or other securities that are undervalued. These undervalued securities have good potential to return to fair value, or higher, over the longer term, but have, for the past five years, remained out of favour, resulting in poor returns.
Passive investments that track market indices may offer lower fees, but do not reduce the risk to which you, as an investor, are exposed, Rousseau says.
An investment in the Alsi ranks consistently in the top quartile of all actively managed general equity unit trust funds, but it has nearly 50 percent of its total value in less than 10 shares and is therefore highly volatile, he says.
Both active and passive investments deliver unnecessary excess risk and neither are optimal for investors, Rousseau says. The failings of both are leading the investment industry into a new era where risk management will be central, he says. The cutting-edge thinking on how to construct a good portfolio is to focus on the correct risk exposure, not merely on picking stocks.
Tools are being developed to serve institutional investors, such as retirement funds, he says. But soon these tools will be available on investment platforms offering low-cost online advice, or your adviser will subscribe to such a service (ratings agency Morningstar is already offering it). Your investments will, however, be invested with a fund manager who uses index investments to control risk explicitly.
While there is no evidence that anyone can predict or model returns, there is now overwhelming evidence that risk can be modelled and can, to some extent, be forecast, Rosseau says. The world is starting to do some interesting research into new ways to manage risk using index strategies.
A move in the investment industry to focusing on managing risks will be a major disruption in an industry that has not seen change in more than a century .
The industry started with a focus on gains, which gave certain investors the ability to identify shares and other securities that would perform well. Then there was a period during which information became widely available and markets were said to be efficient, making it difficult for managers to outperform the market. During this time, the industry turned to passive or index-tracking investments.
Rousseau says the efficient market theory failed to explain why markets crashed, after, for example, the 1998 emerging market crisis, the 2000 technology bubble and the 2008 financial crisis. These events have led to a new understanding of investment markets, where behavioural finance and the irrationality of human investors are key.
The risk cycle is more important than the economic cycle and business cycles, and market crashes and euphoria therefore cannot always be explained with reference to accounting or economic data, Rousseau says. He says if you can engage someone to manage the risks of market irrationality, then you can do better than picking a fund manager who is dogmatically exposed to a particular risk, such as investing in value or growth shares.
As an investor, ideally you want to achieve a return that follows your investment benchmark up, but doesn’t follow it when performance turns down – that is, a true abso-lute return.
Instead, the industry provides investors who choose “absolute-return” or balanced funds merely with a defensive exposure to risk – that is, you underperform in bull markets and you marginally outperform in bear markets, he says.
As a result, there is nothing “absolute” about absolute-return funds, Rousseau says. They are just low-volatility strategies that don’t require skill as defined by the CFA institute.
The only way you can get all the upside without the downside is by actively managing the risk to which you are exposed, Rousseau says.
By combining index strategies that allow investors to capture the excess returns from the risks they take, such as value, momentum or defensive (low-beta) exposures in a portfolio, more efficient portfolios can be designed for investors.
Rousseau says it is not difficult to build a portfolio that simultaneously lowers costs and reduces risk for you, but if you are fully invested in either actively managed funds or traditional passive funds, you cannot achieve this dual benefit.
For example, local investors who are invested with valuation-based managers could lower their risk by combining this with a momentum index fund that benefits from stocks with rising share prices. Combining active and passive investments in this way effectively reduces your cost and your risk without sacrificing excess returns to the market, Rousseau says.
RISKS THAT DELIVER RETURNS
Certain risks your fund manager takes are what are known as “good risks”, which can earn returns for you over the long term.
Exposure to these risks is through strategies commonly used by managers to outperform benchmarks, such as investing for value or momentum. Some managers are stock-pickers and have stock-specific risk, while others invest defensively relative to the benchmark index, exposing investors to what is known as low beta risk.
According to finance professor at the University of Chicago Booth, Eugene Fama, 70 to 90 percent of returns a manager earns for you can be explained because of the manager’s exposure to these investment risks.
You can now also gain exposure to these risks through enhanced or smart index-tracking investments.