It is widely reported that American writer and humourist once said “There are lies damned lies and statistics”.
Twain’s assessment of statistics may have reflected his understanding of statistics themselves. Because to understand statistics you need to understand how they were collected and how those numbers are framed.
It is this detail that actually reveals that many of the statistics investors refer to when investing in managed funds and superannuation are not worth two Jatz crackers.
The problem is that the “league tables” report historical performance. We could argue about its merits and so forth, but it’s easier to tell you a few true stories. Back in the early 1990’s a large bank owned fund manager was just about to release its new PDS. As part of the process the manager’s directors had to sign off the final document. Everyone had signed off the document bar the managing director of the bank.
In due course someone was dispatched to get the managing director to sign. From behind his desk in a small room, the managing director explained he was not happy with the document, in particular the document showed past performance and how did we know that future performance would be the same. Quietly, we actually hoped it would be better, but we will get to that later.
Unconvinced, by our crystal ball the managing director, took a $1 plastic ruler out of his desk, picked up his finest banking blue plastic pen and committed the following to paper, “Past performance is not indicative of future performance, the bank does not guarantee future performance” he then underlined it and said, now put it in bold on the front cover and under everywhere performance tables are shown.
Back at marketing central, there was a complete melt down, how could they sell these funds with that ridiculous statement on the form?
The head of funds management and the chief number cruncher were dispatched into the cauldron to hose the managing director down. After some hours, they reappeared, their win loss record not so good, managing director 100, experts 0.
Because in the end they could not show, how past performance was indicative of future performance.
Which was a good thing really, because one of the funds in the PDS was almost the worst performing funds in it’s a category, over, one, three and five years.
Imagine the how those investors felt, who withdrew during that time or invested elsewhere, when the fund was awarded fund of the year 24 months later and remained in the top quartile of funds in its category for the next decade!
How could this happen? Well we can assure you it had nothing to do with past performance, the league tables or the statistics contained within them. It was more to do with a change of strategy, a change of implementation, a run up in markets and other economic circumstances. But that is a story for another day.
So why do the league tables occupy pages of newspapers, magazines and other media, well, it’s called “white magic”. It takes a mix of well worn investment strategies and past performance. This creates a complex web of intellectual debates and calculations, none of which are exactly right at every point of the economic cycle.
All of this is then mixed with the consumers desire to know, to be involved and for some to talk themselves up as a suburban Warren Buffet.
To accomplish this, the MBA’s and PHD’s of the industry finely distil the turbulent waters of markets, with a mix of the finest investment theories and mathematical models. Generally these are so large and complex that twenty years ago they were merely theories because no computer could compute the answer. There is also a touch of the unknown mixed in to a story that the average consumer can grasp. At the base of this story is the league tables.
They are, the equivalent of when you next fly, the captain says, welcome aboard this Qantas, Airbus A330. That is all we are interested in and frankly all we are probably equipped to fully comprehend.
What he does not say is welcome aboard, 122,000 kilos of plastic, expensive metals, wire and fibre, powered by 2 General Electric CF6-80E1A3 engines developing……..snooore snooore.
In fact so interested are the flying public most passengers can’t pay attention through the safety video, even though over the years there have been 8 critical emergencies on A330’s and many more air accidents.
So Qantas like the investment community has figured out how to make the complex sound simple.
So if the league tables are historical rubbish, what should we look at when we are considering an investment in pooled funds, be they superannuation on managed funds. As a guide we will outline below some of the things we think about before recommending a fund.
The bottom line is that it’s inevitable even the best money managers will at some time lag the broader market, whether it is shares or fixed interest.
Because no one is perfect, except for Bernie Madoff – and we all know the story there.
Recognise there is a lot of luck in the investment business. The vast majority of funds are run by smart people who live and breathe investing. They rise early each morning to hear the latest from around the globe and are at their desks analysing investments while most other people are still getting to work. They work late, attend company briefings, strenuously argue with their colleagues and analyse numbers. They trawl through annual reports and stare at screens looking for opportunities.
In the main money managers are some of the best educated people in the country, and if they were not fund managers, they would be doctors, lawyers and engineers.
They don’t deliberately make bad calls, indeed when you live and breathe markets, you soon understand, what a bad investment is, that being a good investment you paid too much for.
Because you never wake up in the morning and say, gee that is a rubbish business, I think I’ll buy it. The reality is that from the moment an investment manager makes the decision to invest till the moment you read about poor performance, something changed, a Tsunami hits Japan, a central bank raises interest rates, when the economy is weaker than they expected, changes in government policy and so on.
In addition investment managers apply differing investment styles and it only takes a couple of incorrect calls, or a market bias against their style, for a manager to have a poor year, or maybe several.
For instance there are value managers who strongly believe in underperforming stocks like Fairfax and Qantas, and to date, their careers and funds have suffered for their beliefs. Chances are they will at some point be right. One of the things we do is to blend the managers styles, so as to take out the highs and lows, because consistent long term performance is more valuable than a few outstanding years and a few shockers.
It is also true that not all fund managers are created equally, or indeed remain at the same firm for life. We seek to negate the impact of individual people, be carefully constructing portfolios so they are not totally dependent on one person. That is not to say we don’t back managers we like, it just means we know how to mitigate key man risk in the context of a total portfolio.
Our firm knows the managers. We scour the industry for people who have strong records and where we understand their process. We also form views on managers and firms we would not feed. That is the experience we have in our firm from years of working alongside many of the money managers.
So what are some of the things we look at when selecting an investment manager who we can recommend to our clients?
Ignorance is bliss
We ignore short-term numbers. Anyone who carefully selects a manager then sacks them after a year does not understand the nature of the business. How many times have you seen managers written up as demi gods? Yet a few years later they are feather dusters.
When selecting a fund we satisfy ourselves about how a managers investment style, will enhance the investment portfolio, what is there process, risk-taking ability and compliance.
Finally, if short-term underperformance is a major cause of heartache, it might be more appropriate to save the angst and take index performance. In most years, the average active manager does not outperform the index after fees. By definition, despite the considerable talent on the table, most active managers will underperform after fees.
The issue is not that the managers with good track records who go through a poor year or two are suddenly bad managers, but more likely, they have misjudged some short-term event.
But next year, the basic premise might be right. If you’re not prepared to select a manager and hang in there for at least three years and preferably five, you are wasting your time and effort selecting an active manager.
Understand the league tables
League tables represent performance between two points, ie 12 month performance is the last 365 days up to the end of the last month, 3 year performance is the last 1093 days performance.
The problem is that the data is a rolling assessment, that means as a month comes into the tables a month falls out and a fund may have had fantastic performance in month 1 and 2 and dreadful performance for much of the remaining period.
Let’s look at this with theoretical numbers – the theoretical Fund’s performance is:
The 1 year performance is 50%
The 2 year performance is 71%
The 3 year performance is 80%
Now let’s assume you invested just 3 months later – the Theoretical Fund’s performance is:
The 1 year performance is 15%
The 2 year performance is 5%
The 3 year performance is 11%
That means that the annual performance of the fund is in fact 3.7%pa
So what happened, well the first two months in example one were extraordinarily good, one those numbers drop out of the tables the performance falls. Indeed if we dropped out another two months the numbers would be even worse.
If that is not bad enough, the league tables rarely rank funds based on risk adjusted returns. That is how much risk a manager is taking to achieve the returns being reported. Calculating that risk is based on work done by a number of Nobel Economics Prize winning people and is a subject for another day. Suffice to say, absolute returns like the ones displayed above, can be a result of high risk, stupid strategies. Risk adjusted measurements is designed to identify this type of risk taking.
It is a natural human trait to gravitate towards funds which are at the top of the performance tables based on their track record over a few years.
It’s a habit, known as “chasing performance”, and can be particularly damaging to your investment results. Assuming no structural problems it is often the case in markets that last year’s worst performers are next year’s best performers
Something we don’t accept from manager’s we use is secrecy. Sure, a professional stock picker doesn’t want to disclose every trade and trade secret – it might get in the way of them doing their job, but they keep us up to date with what they are doing with your money.
This is particularly important when a fund is going through a rough patch. In fact the worse they go the more we see them. We want to know why the performance hasn’t been as expected, and what they’re doing about it. Managers we use know we understand misjudgement and misadventure occurs in markets, they also know we must be comfortable with the future strategy.
Only pay for what you get, most large managers are commoditised, that is to say they don’t add much value above the index after fees and their fund is very similar to the next big fund manager. So paying high fees for a commodity makes no sense, when there are many low fee options on the market.
Higher fees are only sensible, where you are investing in a specialist field, or a particular manager has a unique skill set. So when we construct client portfolios we seek to pay low fees for commoditised products and apply those savings to area’s we believe value can be added.
In the main however your money is better spent, getting quality personal advice and mentoring from an experienced financial adviser. Because studies show, a greater proportion of financial returns come from asset allocation than it does from stock selection, combine that with good tax and structural advice, plus considered estate planning with consistent investment performance and you will be well placed to achieve your investment goals.