The active versus passive investing debate is ongoing as passive funds such as exchange traded funds (ETFs) continue to outperform actively managed funds. Furthermore, the ratings of your funds could be under pressure.

Should you ditch your actively managed funds and go for the low-fee ETFs or should you switch to a top rated fund? The single most important characteristic of actively managed funds is that they consist of relatively concentrated holdings based on the conviction of the fund managers following in-depth research and analysis.

As the managers tend to look through the cycle with the aim of unlocking value over the long term, the weightings of their holdings may deviate significantly from the benchmark against which they are measured.

Passive funds such as ETFs on the other hand consist of specific holdings and cover the market that they are tracking while the holdings of the index huggers tend to vary slightly from the benchmark or index that they are tracking. Market conditions and cycles are extremely important, especially in strong bull markets, where active managers tend to underperform the broad indices and ETFs due to their conviction and their activities to reduce market risk - that is what you pay them for - is it not?

File picture: Philimon Bulawayo

It is therefore imperative to not only judge and compare funds and their managers on straight performance only, but also on a risk-adjusted performance basis. Fund ratings based on quantitative measures use historical data and they are therefore not necessarily indications of future performances.

The time frames over which funds are assessed are very important. Fund ratings and straight performance comparisons over the short-term can be highly influenced by luck and should be taken with a pinch of salt, as misfortune may befall the fund sooner than later as we saw during the global liquidity crisis in 2008/09.

If a fund’s rating has dropped significantly you should research what has caused it. Has the portfolio manager of the fund changed? Is he taking on bigger risks than in the past?

Has the fund experienced such an inflow that the portfolio manager’s ability to manoeuvre has diminished? Is this the only fund in the investment house’s fold that is underperforming? If not, has there been a major change in the investment team’s investment process? Is the management company concerned about it and what steps are being taken?

Lowly rated funds should not summarily be discarded. A lowly rated fund may have great prospects due to a change of portfolio manager or a change in the investment process of the investment house.

Philosophy

The fund’s assets may have been strategically aligned with the investment house’s philosophy and style and this strategy may have led to underperformance. However, it is crucial that you are satisfied that the holdings of the fund and the fund manager’s track record suit your requirements.

Do not blindly select highly rated funds. Some are highly rated due to their ability to protect more capital than others during downmarket periods, while others are highly rated due to their ability to produce superior returns in strong bull markets, albeit at a higher risk. So, when you are bullish about the markets you should expect divergent returns of the highly rated funds. Use all available tools to track and research the performance of the fund and investment house - the fund’s official fact sheet is a must read.

The highly rated fund’s future prospects may also be in jeopardy due to a change of portfolio manager or merger of management companies or a downward trend in the overall investment performance of the investment house.

Do not ignore funds that have not yet been rated due to a lack of performance history, as they are likely to be nurtured at the beginning by the investment house.

The portfolio manager or investment house responsible for the management of the fund’s assets may also have an excellent record of superior performance and there is no reason why the fund should not eventually achieve a top rating.

Selecting an investment vehicle from all funds available to investors is not a mechanical process and all available information needs careful consideration.

Various factors such as your investment goals, risk tolerance, costs, qualitative aspects and administration efficiencies of the fund management company should be taken into consideration.

Your financial adviser could be of great assistance, especially when you are confused and emotional about investments. Do not get trapped by chasing performance.

Ryk De Klerk was co-founder of PlexCrown Fund Ratings and a consultant for it.

- BUSINESS REPORT