The awful truth about fund managers

If only it was easier: If there was nothing but good and bad fund managers. You could steer clear of the bad ones and put your money with the good ones… forever. But that's not reality. Rather, the real world tells us that fund managers tend to be good for a while and then for a myriad of reasons they are less successful.

The research jargon for this principle is called persistence – or to be more accurate, a lack of persistence. It is perhaps the single most important thing you need to know about fund managers and how they work.

ASIC, in its February 2012 guide related to financial products, emphasises that: “An advertisement for a product with information about past performance should draw attention (unambiguously and without reservation) to the fact that the past performance is not indicative of future performance.” This is a warning that most of us will have seen regularly – although it is one that remains interesting as many funds highlight their past performance in the clear hope of enticing investments on the basis of the expectation of continued superior performance. 

Now, a recent report that considered managed fund performance and can provide some evidence around this issue has come to light: the 2014 Mercer Investment Survey which was published a few days ago. 

The survey was broken up into a variety of categories, including International and Australian shares, and showed the extent to which managed fund performance can fluctuate from year to year.

The international share fund that best demonstrates the extent to which performance can fluctuate from year to year is the Orbis Global Equity fund. A year ago it was the best performing international share fund. However, investors who choose the fund on the basis of that strong performance would have been disappointed this year as the fund fell from the penthouse, to be the worst performing fund (109th).

Investors would also have failed to pick this year's best fund on the basis of past performance – the Acadian Global Beta fund was this year's best performing fund but last year saw it sit in the far more modest 75th position in the survey. 

Do you see a pattern? Here's more: Another modest performer from last year, the Hunter Hall Value Growth fund, jumped 90 places from 103rd to 13th.

More generally no single fund from this year's top five managed to be in last year's top five, and no fund from last year's bottom five remained in the bottom five.

It is important to note that with international share funds there is the crucial issue of currency hedging that can make results volatile from year to year – so while there appears to be enough evidence to question the idea of persistent performance in fund returns, perhaps the Australian share results provides a higher quality of evidence. 

According to the Mercer figures, the two top performing funds of the 138 included funds in the Australian share category were the Tribeca Alpha Plus fund (15.7% before fees) and the Katana Benchmark Unaware fund (13.2% before fees). Considering the local market as measured by the ASX 200 Accumulation Index returned just 5.6% in calendar 2014 these are great returns for investors – but the awful truth is that these funds were respectively the 102nd and 128th best funds in the previous year.

Indeed, the average rank from last year for the top five funds by performance was a fairly modest 70th place. The average rank for the bottom five funds this year (places 134–138 inclusive) was 80th place last year. It's a frustrating set of figures and to be fair it is over a short period of time, so let's look a little deeper at the issue through some recent academic research. 

Measuring persistence

Probably the most famous academic research into managed fund returns is the 1997 paper by Mark Carhart entitled “On Persistence in Mutual (Managed Fund) Performance”, published in the Journal of Finance in 1997. The research involved forming portfolios of managed funds, sorting into groups based on performance, and then seeing what the subsequent return from the managed funds was and, most importantly, if there was a difference in returns based on the previous returns of the group.

His concluding remarks included that while there is some evidence of higher performing funds producing a higher return in the next year, this does not persist in the years after that. A period of higher than average returns from a managed fund has little predictive ability for long-term future returns.

Skill or luck

There are a couple of important take-out messages from this.

The first is to be careful about being overly influenced by past returns when looking to invest in managed funds – the warning that “past performance is not indicative of future performance” is more than just words.

The second is to be careful about what we attribute a period of good investment performance to – thinking carefully about whether it is really skill, or just luck. A skilful investment manager would be expected to be able to pick a portfolio of shares that provides an above average market return year after year – a lucky one will have some good years, and some bad years. Their investment outperformance will not be “persistent”, as we saw with the funds in the Mercer survey.

And we should not just apply this standard to investment managers – we should be humble about the question of skill or luck when we come to evaluate our own returns.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.