Fund managers operate in similar economic and market environments, are presented with similar investment opportunities and even have similar investment mandates, yet performance among unit trust funds can differ markedly. Why is this?
Recently, Glacier by Sanlam tried to answer this question by conducting research into whether qualitative differences among South African fund managers influenced returns. Its study looked at characteristics such as how investment decisions are made, how many investment professionals are responsible for making the final portfolio-construction decision, where fund managers earned their undergraduate degrees, and what postgraduate qualification they have. The findings suggest that such qualitative factors do play a role in performance outcomes.
The research drew on a sample of 87 different fund managers representing 54 asset management companies. These managers were responsible for 146 funds in the Association for Savings and Investment South Africa’s domestic equity general and multi-asset flexible, high-equity, medium-equity and low-equity sub-categories. These sub-categories were selected because they have attracted the bulk of investors’ money over the past few years. The sample excluded multi-managed funds and funds of funds, but it included passively managed funds.
Equity general funds represented 63 percent of the funds in the data-set, high equity 28 percent, flexible and low equity each represented 21 percent, and medium equity 10 percent. The high-equity sub-category was the largest by assets under management, attracting 47 percent of assets, while medium equity was the lowest, attracting four percent of assets under management. The study used five-year performance, measured by cumulative net returns, and risk, measured by standard deviation, between January 1, 2012 and December 31, 2016. Overall performance and risk were averaged across fund sub-categories depending on the fund manager characteristics in question.
Here are 10 factors that appear to influence the returns your fund earns – for better or for worse:
1. Quality managers, quality returns?
Investment style (the way in which a manager selects and evaluates shares) should be one of your key considerations when choosing a fund manager. The research found that 51 percent of the managers sampled said they were value investors, which means they buy shares they believe the market has undervalued and sell shares they believe are overvalued.
Seventeen percent of the sample said they were quality investors. There is no universally accepted definition of a “quality” asset. Quality investors typically choose shares of companies that are characterised by low debt, stable earnings growth and other “quality” metrics, such as a high return on equity, stable dividend growth, a strong balance sheet and cash flows, and good management.
Seven percent said they were growth investors, who look for shares they believe have the ability to outgrow the market – they focus on the future prospects of a company.
Twenty-five percent said they were style agnostic: they may employ different styles depending on opportunities and environment.
The research found that managers who followed a quality style produced the best returns between 2012 and 2016, while value managers performed worst. However, Leigh Köhler, the head of research at Glacier by Sanlam, says investors should be careful about reading too much into these findings. “The dominant market cycle during the time of the analysis should be taken into account. Second, in practice, fund managers in South Africa are often wary of constraining their investment philosophy to one style, hence the relatively large proportion claiming to be style agonistic. It is also not uncommon to find managers who claim one style but employ another.”
2. A big team doesn’t mean underperformance
Köhler says a school of thought within the investment industry holds that large investment teams tend to slow down the investment process (from idea generation to portfolio construction) and, ultimately, cause underperformance. But is this really the case?
“The investment team is the individuals who are responsible for the research that informs instrument selection and portfolio construction. The more resourced an investment team, the wider the breadth and coverage of research. This is particularly relevant to bottom-up, fundamental analysis. However, with improving screening technology and the advent of passive investing, artificial intelligence and machine learning, the relevance of team size has been brought into question,” says Köhler.
The study found that the average size of an investment team supporting fund managers is 11 members. Therefore, an investment team with fewer than 10 investment professionals is relatively small, and one larger than 10 is relatively large, he says.
The research indicated that larger teams generally performed well: funds with investment teams of between 34 and 36 members generated the best average return over five years (13.16 percent) at a lower level of risk. However, teams of between one and three members also produced a good return (12.42 percent), although at a higher level of risk (see Table 1).
Köhler says the results do not indicate that there is a clear relationship between team size and returns, but they do seem to provide some evidence that large investment teams do not necessarily act as a constraint on performance.
3. Many heads are better than one
The final decision on how a portfolio will be constructed can be made by an individual or a team. Of the funds sampled, 68 percent had a team-based decision-making process, with an average of three investment professionals directly influencing the final decision. An individual made the final decision in 27 percent of the funds, while five percent of the funds said they used both approaches.
Funds that used team-based decision-making outperformed those where one person made the decision: returns of 11.28 percent and 10.77 percent respectively. Funds where both an individual and a team made the decision fared worst, at 6.77 percent – and while taking the most risk. Funds where a team made the final decision were willing to take on more risk than funds where one person made it.
Table 2 shows the relationship between who makes the final decision and returns by sub-category. In some cases, individual decision-making produced better returns, while in others team-based decisions worked best. What is clear is that, across all fund sub-categories, funds where there is a lack of clarity over whether the final decision is made by a team or an individual produced the lowest returns.
The final portfolio-construction decision can be driven by an investment model or the manager’s intuition. The research found that 50 percent of fund managers relied on a model, 47 percent used both a model and intuition, while only three percent used “gut feeling”. The research suggests that, where fund managers use both a model and intuition, they outperform at lower levels of risk across all sub-categories (see Table 3).
Köhler says it is noteworthy that some managers of equity-centric funds are prepared to rely solely on their gut feeling when constructing the portfolio. This is not the case where a fund’s mandate is to invest across all the asset classes.
4. Diversity is strength
The research found that the South African fund management industry is dominated by white men. The average female representation in investment teams was 18 percent, while the average representation by previously disadvantaged individuals (black African, coloured and Indian) was 31 percent.
As Table 4 shows, investment teams that had achieved employment equity of between 70 and 80 percent produced the highest returns over five years (13.79 percent) but at the highest level of risk. The best risk-adjusted returns (relatively high returns at lowest risk) were produced by teams with employment equity of between 40 and 50 percent.
Although there is no clear relationship between levels of diversity and returns, Köhler says the research suggests that diversity results in higher performance.
5. Co-investment doesn’t equal higher returns
Co-investing is when fund managers invest in the funds they manage. Higher levels of co-investment are associated with higher levels of alignment between the interests of the fund manager and their clients. But do high levels of co-investment result in higher returns?
The research found that 85 percent of the managers sampled did co-invest. However, of these, 62 percent invested less than half of their discretionary wealth in their funds. “So, while the number of managers that co-invest suggests client-interest alignment, the level of co-investment may suggest otherwise,” says Köhler.
Twenty-six percent of the managers invested more than half of their discretionary wealth in the funds they manage; three percent invested all their discretionary wealth, and 10 percent did not disclose their level of co-investment.
The results set out in Table 5 show that co-investment did not necessarily result in the highest returns: those managers who did not co-invest outperformed those who invested less than half or more than half of their discretionary wealth – and at lower levels of risk. However, among managers who did co-invest, managers who would not disclose their co-investment level produced the best returns over five years (12.03 percent) and at the lowest level of risk.
6. Share ownership means better returns
Fund managers are often incentivised with the ownership of shares in the companies for which they work. The research found that 81 percent of managers owned shares in their asset management companies.
Share ownership is often associated with higher levels of interest between the fund manager and the asset management company, but does this also translate into better outcomes for investors? The research suggests that it does: managers who owned shares produced a return of 11.28 percent over five years, compared with 9.44 percent by those who did not own shares in their company.
Köhler says it is also noteworthy that the managers who owned shares in their companies were willing to take on more risk than those who did not (8.18 percent compared with 7.46 percent).
7. Independent managers don’t always shine
You might assume that funds managed by a company whose sole concern is asset management – the likes of Allan Gray, Coronation and Foord – will outperform funds affiliated to companies where asset management is only one of the group’s activities. However, the research does not bear this out.
The funds (only two percent of the sample) associated with the single wealth management company included in the data-set produced the best returns (15.41 percent) over five years. The funds associated with asset managers affiliated to banks and the funds of independent asset managers produced comparable returns, 11.19 percent and 11.25 percent respectively, over five years.
Most of the funds (59 percent) in the sample were affiliated to an independent asset manager, while 27 percent were associated with a life assurance company and 12 percent with a bank.
When the returns were analysed by sub-category, the banks and the wealth management company did best with equity general and high-equity funds, while independent asset managers produced the highest returns in the flexible, and medium- and low-equity sub-categories.
8. Managers with MBAs outperform
Does your fund manager have a Master’s in Business Administration (MBA)? It seems you should hope so. According to the research, managers with an MBA produced better returns (11.58 percent) at lower levels of risk than managers without one (average return of 10.77 percent) over the five-year period. The observation that MBA graduates produced higher returns held true across all the sub-categories, except the flexible sub-category. “The evidence also suggested that managers with an MBA took on less risk across all sub-categories to generate returns,” says Köhler.
Globally, the Chartered Financial Analyst (CFA) qualification has become recognised as the “gold standard” for investment professionals. But, says Köhler, the research found that managers with a CFA underperformed (a return of 10.24 percent) those who were not CFA charterholders (11.59 percent) – and they did so while taking on higher levels of risk. “The observation that non-CFA managers outperformed CFA managers over the five-year period held true across all fund sub-categories,” he says.
Managers who are Chartered Accountants (CAs) outperformed (11.68 percent) non-CA managers (10.65 percent). This seemed to be the case with all the sub-categories, except for high-equity and low-equity funds. However, it seems that managers who were CAs were willing to take on more risk to generate higher returns.
Of the managers sampled, only 18 percent had an MBA, whereas 49 percent were CFA charterholders and 27 percent were CAs. Five percent of the managers had both an MBA and a CFA charter; only one percent had an MBA and were CAs; and 17 percent were CAs and CFA charterholders.
9. Top universities don’t always produce the best managers
Most South African fund managers (46 percent) obtained their undergraduate degree from the University of Cape Town (UCT), and 64 percent of managers graduated from one of the Tier 1 universities: UCT, Witwatersrand (10 percent) and Stellenbosch (eight percent). Thirty percent of the managers attended a Tier 2 institution (the rest of South African universities) and six percent graduated from an international university (Tier 3).
The average highest performance (13.25 percent) over five years was produced by the managers – only two percent of the sample – who obtained their undergraduate degree from the University of the Free State. The lowest returns (8.69 percent) came from managers who went to the University of KwaZulu-Natal (six percent of the sample). However, Köhler says there was no significant difference in the overall returns among managers who attended Tier 1, 2 or 3 institutions.
Managers who attended Tier 2 universities produced the highest performance across all fund sub-categories except for multi-asset low equity, where Tier 3 graduates fared best.
10. Age and tenure influence returns
You might assume that managers who have managed the same fund the longest will do better than those whose tenure with a fund is shorter, but this is not the case. The research found that managers with a tenure of more than 21 years produced the lowest returns (7.12 percent), and at far higher levels of risk, whereas managers who have been with their funds between 16 and 17 years produced the best five-year returns (14.05 percent).
By fund sub-category, managers with a tenure of 16 to 21 years produced the best returns in equity funds, while those with 11 to 16 years’ tenure outperformed in the flexible and high-equity sub-categories.
The average tenure of the managers sampled was 7.7 years, with the shortest tenure being six months and the longest 17.6 years.
The research suggests there is a correlation between the age of a fund manager and returns. Managers between the ages of 45 and 49 produced the best returns (11.96 percent) at relatively moderate levels of risk, whereas managers between 35 and 39 produced the lowest returns (9.39 percent).
When returns were analysed by sub-category, the research found that managers over 60 years performed best in the equity general and low-equity sub-categories. Managers above the age of 45 performed better in the flexible, high-equity and medium-equity sub-categories.
The average age of the 87 fund managers sampled was 47. The oldest manager was 64, while the youngest was 30.
What does the research mean for you?
So, if we want to invest in unit trusts that will outperform, should we choose funds managed by 46-year-old managers with MBAs who have been managing their funds for 16 years, follow a quality investment style, and where the portfolio-construction decisions are made by a racially diverse team? No, this is not the take-home lesson.
Köhler says it would be unwise to make investment decisions based on a single study. The research needs to be repeated, to see whether the suggested relationships between the qualitative factors used in this study and returns recur over more than one period.
Second, the research did not delve into why the qualitative factors appeared to influence returns. The adage that “correlation is not causation” should be borne in mind. Köhler says the release of the findings has led to “many interesting conversations” between asset managers and Glacier by Sanlam about what they mean. His research team will be unpacking the findings and conducting follow-up studies in an attempt to ascertain the nature of the relationship between the qualitative factors and returns.
In the meantime, Köhler says the research supports Glacier by Sanlam’s view that looking at past performance alone, whether straight or risk-adjusted, is woefully inadequate when choosing fund managers. Investors need to take a closer look at whether an investment manager has the characteristics and capabilities that will enable it to growth their wealth.