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The 2017 Mid-year SPIVA South Africa scorecard (published by S&P Dow Jones Indices) reported that 84% of local equity funds trailed their benchmark over the five-year horizon. Yet just about every performance graph the industry puts up shows benchmark-beating returns.
How do we reconcile the two?
Standing in the shadows
The obvious point is that the industry proclaims only its winners. Almost all investment stables race multiple horses so at least one of their funds is likely to stand out as a leader at any time.
The wide scope of categories at the Raging Bull awards, which is described as “celebrating the stars of SA investment”, provides a marketing opportunity for just about everyone.
Turning the spotlight on the winners not only attracts attention and money, it also casts a shadow that obscures the losers.
Losing the losers
Some funds do well over a number of years and attain “flagship” status, while others are repeat laggards and settle at the wrong end of the rating table. They suffer outflows and do nothing for the manager’s reputation, so it makes no business sense to keep them going.
They can’t be closed down officially, though, because that risks losing face, or assets. Instead the investors are transferred to a more “relevant” fund and assume that fund’s track record. With any luck, they soon forget they did not have a share of the returns that created the track record to which they are now aligned.
According to the SPIVA South Africa Scorecard, 23 of the 134 equity unit trusts listed at the beginning of the five-year period did not survive. At that rate, more than half would disappear over 20 years. Removing failures makes asset managers and the average industry return look better. This is the so-called survivorship bias.
An alternate type of survivorship bias relies on incubation funds. An asset manager may seed start-up funds privately, and then market the top performer to the public. A few start-ups adopting a high-risk strategy should deliver at least one with an outsized return.
The high initial performance is embedded in the fund’s “return since inception” and can create the illusion of long-term outperformance, even if the 5, 10 or even 15-year return reveals a fading or even negative ‘alpha’ (benchmark-relative return). That is almost inevitable, because strong returns attract strong inflows, and it is much harder to beat the market with a large fund than a small one.
Outperformance is a relative measure, but the question is: relative to what? In the past, the FTSE/JSE All Share Index was a popular measure. But it is not really appropriate because it does not reflect local ownership of the underlying companies.
It’s an easy hurdle when large multinationals, with a secondary listing on the JSE, underperform. And when they outperform, the answer is to change the benchmark (which is what some of these funds eventually did).
The JSE’s SWIX (shareholder-weighted) indices adjust for foreign ownership, as does SPIVA’s benchmark, the SA Domestic Shareholder Weighted (DSW) Index. These are more relevant approximations of our market’s return.
Multi-asset funds set subjective benchmarks
Owing to their variable nature, there is no independent yardstick for multi-asset funds, which may explain their popularity in the industry. They set their own benchmark, either absolute (eg CPI +5%), or relative (the average performance of other funds in this category), or based on the market return of a pre-determined asset allocation. Using such measures can suggest outperformance even where a fund lags the return of a comparable market portfolio.
Objects in the rear-view mirror
Another way to look like a champion, favoured by fresh-baked multi-asset funds, or fund-of-funds, is to show the returns they would have earned had they started investing sooner. This so-called back-testing creates the illusion of a track record where none exists. And it allows the manager, with the benefit of hindsight, to choose a strategy that would have done well in the recent past. Such reporting is subject to disclosure, but the implications of that may be lost on lay investors.
Yesterday is gone
Or, as a variation on this theme, a manager might modify a losing strategy and thereby change the past. A very recent and very public example is that of a fund ranked as the worst performing multi-asset high-equity unit trust over one, three, five and 10 years. A confluence of factors, brought about by appointing a new manager ‘necessitated’ a change in investment policy and allowed the fund (with Asisa’s approval) to shed its terrible performance history. A bit like a snake shedding its skin.
All’s fair in love and marketing
The irony is that none of these practices fall foul of the FSB’s TCF guidelines. The prerequisite disclosure and disclaimers make sure of that.
But it does beg the question why all fund literature warns that past results do not indicate future performance, when the industry’s behaviour, in terms of what it markets, how it hires and fires managers and how it recommends funds, suggests the opposite. It would not emphasise winners, manipulate relative performance or throw an invisibility cloak over losers if it did not think it affected investor behaviour.
In a world of finite returns, maintaining the illusion that all investors can be above-average is a marketing triumph. But for millions of clients – unaware that the odds of beating the market are less than even and that trying to do so can cost a fortune in fees – the financial consequences of heeding this message are often tragic.