It's a nuisance, but you just can't completely outsource your financial affairs. The bottom line is that it's your bottom on the line.
That's even the case when you have outsourced your stock picking to a professional via investing in a managed fund. Your fund manager chooses the shares, but you choose the fund manager. And that replaces one problem with another - how do you figure out which investment house will be best with your hard-earned cash?
Isolating an outperforming manager is no minor issue. Dedicated readers of Smart Investor Money will recall our article in June that revealed barely two in every five large-cap funds (those that invest in the biggest listed companies) had beaten their benchmarks in the previous three years, according to Standard & Poor's analysis.
Most of our equities money is in the larger, "core" Australian equities funds. And that means you need to be smart about how you go about picking a manager.
Unfortunately, too many of us are doing it the wrong way. In particular, we focus excessively on how a fund has performed and not enough on forming a more nuanced view on how we think it will perform.
Raise your hand if you've heard the phrase "past performance is not a reliable indicator of future performance". Now raise your other hand if an investment manager's track record plays a central role in your decision of whether to choose it over another. The fact that most of us are reaching for the sky right now is what you get when a warning becomes so rote that we start filtering it out - much like smokers and the graphic warnings on cigarette packs.
But as is the case for smokers, the warning to not chase past performance "really does mean something", Jonathan Ramsay, head of asset consulting at van Eyk, says. He set out to prove just that.
Ramsay identified 10 instances where managers beat the market by 5 percentage points annually over three years. Did a three-year period of outperformance give a good guide to future performance? Absolutely not.
"Even looking at the best track records over the past 20 years, more often than not you'll be disappointed if you invested solely on the basis of past performance," Ramsay says. "Experience suggests that there is either a reversal or a plateau."
On these results you would actually be better picking a manager that has underperformed in the previous few years.
Yet anecdotally and intuitively, high-performing funds tend to attract more money - and the longer they outperform, the more cash they bring in. That means many will get in too late in the story and their returns will suffer as a result. It's the old curse of "buying high and selling low".
The key is to think of it in terms of valuation, because that's the cornerstone of most professional investors' processes - they want to buy companies at the point when the market underappreciates the potential for earnings growth. A fund that has been on a tear for quite some time may have been riding a trend that is almost on its last legs. A good manager should dump the stocks where value has been realised and reinvest in underappreciated companies. Yet history suggests many don't - why not?
"They're people," Ramsay shrugs, "and in practice it's quite difficult to do."
Partly it's psychological: it's hard even for the pros to cut loose a cherished winning stock. "These are [investments] you feel good about and which have served you well," Ramsay says.
So what's the best approach to selecting a manager? First off, as we've established, don't obsess about past performance.
Next, have a look at how the research houses such as Lonsec, Morningstar, and Zenith rate the fund - managers will advertise their rating if it's a good one and those agencies consider a wide range of factors, not just performance.
Finally, you need to take a view on what the world will look like in the coming few years and then choose a manager whose style and portfolio reflect your opinion. A few years back that would have meant having a bias for managers who invest in "quality" stocks - ones with sustainable earnings and strong balance sheets. That suited the volatile and range-bound sharemarket. But after a strong run, will that story continue? It may, if the troubles in Europe, China and the US worsen then they will remain the kind of funds you want exposure to. But if not, then a manager that is relatively overweight in cyclical sectors - such as discretionary retail and miners - could be the star performers in coming years.
And even if these managers continue to lag the market in the short term, at least you'll be prepared and won't be tempted to disinvest at the worst time.
"The Platinum International Brands Fund struggled a little bit at times, but when you did get that cyclicals rally early in the year they outperformed markedly - a little bit of a sign there," Ramsay says.
Of course, you can outsource your outsourcing, as it were, by letting your financial adviser pick the fund for you. Even then you need to spend time finding an independent and savvy planner.
Ramsay sums it up: "The manager is actively managing a portfolio on your behalf, so you need to take a little bit of ownership". Or a lot.
Frequently Asked Questions about this Article…
Why can’t I completely outsource my investments to a fund manager?
You can outsource stock picking to a managed fund, but you still choose the fund manager — so the ultimate outcome is your responsibility. As the article says, it’s your bottom line, and you need to take some ownership of the decision about which investment house handles your money.
Is past performance a reliable way to choose a managed fund or fund manager?
No — past performance is not a reliable indicator of future results. The article cites Standard & Poor’s finding that barely two in five large‑cap funds beat their benchmarks over the prior three years, and Jonathan Ramsay’s work showed many managers who outperformed over three years did not continue to do so. Relying only on recent track records can be misleading.
What evidence shows chasing past winners can hurt my returns?
High‑performing funds tend to attract lots of new money, which can push them into buying high and reduce future returns — the classic ‘buy high, sell low’ problem. Ramsay also found examples where three years of outperformance did not predict continued success, suggesting late inflows and size can hurt future performance.
How should I use fund ratings from research houses like Lonsec, Morningstar or Zenith?
Treat ratings as a useful input because agencies such as Lonsec, Morningstar and Zenith consider many factors beyond pure returns. The article suggests checking these ratings to get a broader view of a manager’s process, risk controls and consistency, rather than obsessing over short‑term performance alone.
What role does valuation play when selecting a fund manager?
Valuation is central: professional investors look to buy companies when the market underappreciates potential earnings growth. A good manager should sell stocks whose value has been realised and reinvest in underappreciated opportunities, so understanding a manager’s valuation approach helps you judge whether they’ll avoid buying overpriced trends.
How do I match a manager’s investment style to my view of the market?
Decide what you think the world will look like over the next few years and pick a manager whose style fits that view. For example, if you expect more volatility and range‑bound markets you might favour managers who pick ‘quality’ stocks with sustainable earnings and strong balance sheets; if you expect a cyclical recovery you might prefer managers overweight in cyclical sectors like discretionary retail and miners.
Can I let a financial adviser pick funds for me, and how do I make sure they’re doing a good job?
Yes — you can let an adviser pick funds, but the article recommends finding an independent, savvy planner and still spending time on the decision. Even when outsourcing, you should check the adviser’s rationale, the fund ratings they rely on, and whether the chosen manager’s style matches your market view.
What practical steps can everyday investors take to choose a better fund manager?
Don’t obsess about short‑term past performance. Use research house ratings (Lonsec, Morningstar, Zenith) as part of your assessment, evaluate the manager’s valuation process and behavioural tendencies, match manager style to your market outlook, and stay involved even if using an adviser. The article also notes examining real examples — such as how the Platinum International Brands Fund behaved in a cyclical rally — can reveal whether a manager follows their stated process.
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