This article was first published in the second quarter 2017 edition of Personal Finance magazine.
It is not surprising, but it is significant: investors tend to be drawn to the performance figures that look the best, regardless of the critical factor of time in the market. It is so familiar that there is a name for it: myopic loss aversion. The term was coined by United States academics Shlomo Benartzi and Richard Thaler in 1995, when they identified a number of biases that affect investors’ choices, often to their detriment.
The key issue is this: after being exposed to shorter-term performance figures of bonds and equities, investors tend to choose conservative portfolios weighted on the side of bonds, rather than equities. However, when given the longer-term performance figures of exactly the same assets, they choose riskier portfolios. This is a response to the fact that, over shorter periods, bonds may outperform equities, whereas, over longer periods, equities have a tendency to outperform bonds. In other words, the period in which returns are framed is critical to the investment decision, because, to the investor, the pain of experiencing losses is more compelling than the joy of making gains.
A recent example of short-term pain/long-term gain played out in the performance of a particular South African general equity fund, the PSG Equity Fund. First, we rewind to December 31, 2015. The fund delivered a negative return (-6.4 percent) for the year. What’s worse, from its high in April 2015, the fund suffered a drawdown of -15.5 percent to December 31, 2015. The JSE delivered 5.1 percent for the year and suffered a drawdown of only -5.1 percent between April and December of that year. Clearly, the fund’s performance was poor, and most investors would find this difficult to stomach.
Investors were selling
The pain, however, was not over, and the fund continued to deliver negative monthly returns until January 2016. How did investors respond? Well, they started selling out of the fund. This was regrettable, because it was one of the best-performing general equity funds in 2016, delivering 25.1 percent for the year. Furthermore, the performance was achieved with an average exposure to resources of only 11 percent and an offshore exposure of 23 percent, which was close to its maximum allowable exposure of 25 percent.
The fund's performance is particularly impressive when one considers the strong performances of resources over this period and the adverse effect a strengthening local currency had on offshore investments. Over this same period, the FTSE/JSE All Share Index (Alsi) delivered only 2.1 percent.
If we go on to compare the returns over the past two years, we see some significant differences in performance. Since December 31, 2014, the PSG Equity Fund delivered 17.1 percent (an annualised return of 8.2 percent), while the JSE delivered 4.1 percent (an annualised return of only two percent). The PSG Equity Fund therefore outperformed the JSE by 6.2 percent a year over the past two years. Granted, this is over a very short term, but it does put the fund’s negative returns and drawdowns of 2015 somewhat in perspective. If investors were spooked by the poor performances of 2015, they would have missed some very good subsequent returns during 2016.
Looking at the fund’s 10-year history to the end of December 2016, the PSG Equity Fund exhibited an annualised tracking error (which reflects the volatility of realised relative returns) over this period of about 8.53 percent. Roughly, this means that, over a one-year period, there is a 33 percent (one in three) chance of this fund delivering +/- 8.53 percent relative return versus the Alsi. In other words, If you want performance that is different to the benchmark, you will get performance that is different to the benchmark! The significance of this is that investors need to make sure they understand this and that they are indeed able to stomach times of relative underperformance.
Impact of investor behaviour
Investors tend to sell out of, and buy into, funds at the wrong time. This largely explains why investors’ actual performance experiences are almost always different to the published fund returns, a phenomenon driven purely by poor investor decision-making.
Equity as an asset class is risky – this we all know and accept – and therefore returns usually materialise over longer, rather than shorter, time horizons. If we accept this, why are we not willing to stomach short-term volatility?
Back to myopic loss-aversion. As humans, we suffer from a number of biases, and we should accept that. Once we accept this, we are better at trying to identify our own emotional or cognitive biases and respond accordingly. Clearly, losses are painful compared with the joy we experience when it comes to gains.
Consequently, investors need to pay more attention to how losses are framed and to realise that risk and reward go hand in hand. Portfolio managers need to be given the space to take appropriate “risk” so that longer-term capital growth may be realised.
Importance of financial advice
Investors need to make sure that their willingness and ability to take risk are adequately reflected in their underlying investments. It is crucial to obtain the professional advice of a financial adviser when trying to estimate your risk profile and choose your investments. As long as your risk profile is unchanged, you should stay invested for the long term, despite short-term volatility or poor performances. Of course, this is true only if you have done proper research into the managers you have selected to manage your hard-earned money. If you have been chasing performance, you will run into difficulties in the future.
Valid reasons for selling out of a fund are that your investment thesis for choosing a particular manager has changed, or there are qualitative concerns about the sustainability of the fund manager’s business, the team, the investment philosophy, or the investment process.
With regards to the PSG Equity Fund, Glacier maintains its positive view on the fund, the team, their philosophy and the process. The fund is on Glacier’s Shopping List – the range of funds Glacier rates highly and which have delivered consistent, superior relative returns over longer, more meaningful periods, to the benefit of investors.
In conclusion, the next time your more risky investments underperform, ask yourself what has changed. Are there material qualitative concerns when it comes to the managers you have selected, or is the underperformance a natural part of the risk/reward spectrum? Your financial adviser, together with your investment platform’s research team, can make a significant contribution to answering these tough questions.
Francis Marais is a senior research and investment analyst at Glacier by Sanlam.