IN BLACK AND WHITE

 

Don't faff about

If you are a regular reader of some of the more prominent financial websites you will be aware that there is some real animosity towards “financial advisors”. Apparently collectively we have little ability to identify our gluteus maximus’ from our olecranon process’.  1

However, the term financial advisor captures a very broad category of practitioners. There are those that deal with risk products (insurance and medical aid); those specialising in investments (retirement, wealth creation, education planning) and finally the fiduciary specialists (estate and tax planning). Lumping them all together creates problems because the skill and experience required for each discipline are very different indeed. You don’t consult a lawyer for your medical needs so why take investment advice from an insurance specialist?

“Financial Advisor” is not a title you need to earn, so just about anyone can be armed with this designation and unfortunately for the industry at large “just about anyone” has been. Many of the so called “top” financial advisors with the more prominent industry players seem to “earn” that accolade for how well they are able to meet and surpass their sales targets rather than how well their client’s objectives are met.

The trouble with identifying a good “financial advisor” is that there is no benchmark or peergroup to base any relative comparison on. It is apparent from many conversations with prospective clients that their benchmark of a good advisor often includes having the ability to pick the top fund(s) to invest in.

I thought it may be useful to provide a small case study on the appropriateness of this expectation and to expand on why one might term this activity Financial Advisor Folly – or FAF(f) for short.

Unlike financial advisors, fund managers have to publish their performance on a regular basis. This means that we can measure them against a benchmark (be sure it is a suitable one) or their peergroup (their competitors who provide similar products). We then have some idea of who has been able to achieve their stated objectives (consistently over a prolonged period) and justify the fees they charge for delivering on that promise.

A graphic of the number of active fund managers in South Africa that can consistently beat the JSE All Share index (Peergroup: Domestic General Equity Sector) looks like this as at 30 June 2015:

How difficult is active fund management

Source: White Investments, Personal Finance & ProfileData as at 30 June 2015.

It is obvious from the graph that the majority of active managers struggle to beat the broad market index. Since the promise of superior returns is one of the main reasons why we would consider employing an active manager this is a crucial statistic. 2

If we consider the 5 year time horizon, only 1 in 4 managers (25%) beat the index.3 It suggests we would require the ability to select a fund from the small group of winners out of the 84 funds within the South African General Equity Sector to add value.

Is picking a winner as simple as looking at the top performing funds today and assuming these must be the best guys to go with?

Well if we consider how many of the top 5 managers today, were in the top 5 group five years ago, we would find that it was exactly ZERO. That implies that to consistently pick the top performer we would need to switch or trade funds in all likelihood.

How frequently would we need to switch or trade?

If we consider how many of the top 5 managers today, were in the top 5 just two years ago, we would find just ONE. If only 20% of the current top 5 managers were in the group just two years ago, it seems that using recent performance as a predictor has a fairly low success rate over short time periods. We would clearly need to trade regularly between funds to consistently own a top performer.

What drives the relative performance of funds ?

The average TER (Total Expense Ratio = fund manager costs) is 1.67% for the top 5 managers and 1.62% for the bottom 5 managers. So it would appear that fees alone cannot be the driving factor between being in the top or bottom range of funds. Note: We pay the fee regardless of whether the manager delivers or not.

Furthermore, if you take the market index return (JSE All Share) and merely subtract the average fee of the bottom 5 funds you would have a return of 16.42%. But the average return of the General Equity Sector over 5 years was only 15.29%, which would anecdotally  imply that the underperformance is not only due to the impact of active fees but must also involve poor active decisions that translate into lower returns relative to the market.

Active managers are professional investors so how wrong can they be?

When an active fund manager underperforms they can do so in a spectacular fashion. Consider the gap between the best and worst performer over the 5 years to the end of June 2015.

The best performer, Harvard House BCI Equity, returned 22.25% per year over the period. The worst performer was Momentum Value Fund which managed just 1.69% per year over the same five year period.4

If we had invested R1 million in each of the best and worst performing funds over the five year period, the difference between the two would be R1.64 million. That is quite spectacular when you consider that both investments have assumed the higher risk or volatility of equities to try and generate a more favourable return outcome over time. Clearly there is no guarantee here.

The reward for picking the best fund would have yielded an additional R438,000 over the five year period, in excess of the equity market return. Remember we have  a 1 in 84 (1.2%) chance of picking the best fund in the sector and a 25% probability of picking a fund that provides a better performance than the market index (passive fund).

So we know the odds of picking a winner are stacked against us but we can also see that if we picked the worst fund we would be R1,200,000 worse off than the market or index return. The downside risk is therefore almost three times the reward for picking the best fund. I would consider this an unattractive risk/reward ratio.

Perhaps more importantly we have a 75% chance of selecting a fund that performs worse than a passive index tracking fund over the five year period. Even if we had received the average Sector return we would have been worse off than the market index and a simple passive tracker ETF.

But if we can select the best manager consistently surely it must be worth the effort?

Even if we back ourselves to pick the winners consistently, we would probably be exposed to trading more regularly as we illustrated earlier. More regular trading could increase our trading costs but it will almost certainly increase our tax bill. If our investment returns are deemed to be trading profit, they will be taxed at our marginal rate of tax rather than the significantly lower Capital Gains Tax rate.

We can illustrate this more effectively by comparing the best active fund over 5 years, assuming the returns are treated as income, relative to the passive ETF returns, which we buy and hold for the period and assume the returns are treated as capital gains:

 Tax implications of investment decisions

What becomes apparent may not initially be as obvious as it is intuitive. The returns from the top active fund are better on a nominal (pre-tax) basis. But  given that we would probably have to trade to consistently hold the top fund, the different tax treatment would make a buy and hold strategy on a passive fund the better performer on an after tax basis.

Therefore, in the context of investment strategy, for us to achieve our stated mission of “making a difference”, we must try and deliver a strategy that will provide the greatest possible certainty or probability of success.

When we are seeking out an investment to meet a client goal we are concerned with our ability to maximise the probability of achieving a specific required return (more precisely a specific return after fees and taxes). This does not mean we are  trying to pick the best fund manager or fund out there. It means we want to minimise the opportunities for disappointment.

There are clearly some very talented active managers out there but as the above discussion shows, it is extremely hard to pick them consistently. And even if we can pick them, we must be certain that our active strategy delivers returns in excess of our passive options after tax.

We cannot predict or control market returns but we can choose funds with known lower fee structures and we can control our behaviour in such a way as to minimise the future tax liability our investment returns attract. This increases our certainty of returns and raises our probability of reaching our client’s end goals.

It may be helpful to look at the comparative results of the various investment options over the five year period to the end of June 2015, assuming a starting value of R1 million:

 Investment options

Source: White Investments, Personal Finance & ProfileData as at 30 June 2015. Top Active = Harvard House BCI Equity (22.25%), Worst active = Momentum Value Fund(1.69%),  cash (5.75%),  the RMB Top 40 passive ETF (17.74%), the General Equity Sector Average (15.29%) and inflation of 7%.  

-  The worst active fund provides less rerturn than cash in the bank.

- The damage of picking the worst fund is 3x worse than the reward for picking the top fund relative to market returns.

-The passive ETF portfolio delivers a better return than the average of the general equity sector.

- Since we are not trying to outperform with a passive fund we can follow a simple buy and hold strategy which enhances after tax returns.

- Cash and the worst active fund fail to maintain our purchasing power over time. They do not grow ahead of inflation.

If you partner with White Investments to help you achieve your life goals you should expect us to deliver a strategy that provides you with the greatest probability of success. It will have nothing to do with our ability to predict market returns or forecast which active funds will be at the top of the peergroup over any specified period.

It will be about our ability to understand your goals and use our knowledge and experience in the industry to put together a investment strategy that provides you with the best chance of succeeding. 

So lets not faff about  – Lets focus on the factors within our sphere of influence or control.

 

1 Our bottoms from our elbows.

2 Basing anything on historical performance at a single point in time is dangerous as the numbers work on a rolling basis - If a fund has a particularly nasty year/month/quarter of relative performance fall out of a specific time period, they can leapfrog to some pretty decent looking numbers over short space of time (and the reverse is also true). It is also wrong to consider returns in isolation - If a fund manager can achieve a return similar to the benchmark but at half the risk then he is also providing a valuable service. Unfortunately risk statistics over comparable periods are not readily available to the public.

3 Some of the higher percentages for outperformance are over the very short term (1 year) and again over the very long term (15-years or more):

-Over the short term particular investment styles (Value, growth, momentum) may work better than other. Sector bets (like being underweight resource stocks) has helped boost the performance of SA managers in recent times. But overall, the numbers seem to indicate that it is harder to consistently outperform over time and so we see a drop off in the percentage of funds that beat the market over 3,5 and 10 years. The sceptics would suggest that much of the success over short time periods is the result of luck rather than skill. No one wants to pay a manager for being lucky - they are paying high active fees for the manager’s skill to deliver consistently.

-Over the long term the proportion of managers that beat the market index is higher. This however is largely due to a phenomenon termed survivorship bias. The funds that don’t beat the index over the first 10 years are less likely remain in business, leaving the universe of funds with more of the winners and fewer of the underperformers as time passes.

4  We have not conducted extensive analysis of these two funds nor are we familiar with the fund managers responsible for either fund. A cursory look at both funds however reveals potential reasons for the relative performance. The Momentum fund follows a value style which means they seek to buy companies that are trading below their intrinsic value in the expectation that the market will reward them eventually. A higher allocation to the resources sector is typical of value funds today and go a long way to explaining the underperformance on a relative basis. I believe the Momentum fund took a large position in African Bank too which was a real wealth destroying move as there is no prospect of a recovery. Harvard House on the flip side appears to have had a very strong bias towards the property sector which was by far the best performing industry in recent times and is therefore reflected in their strong relative performance.

If you have any questions relating to the contents of this article please contact us at info@whiteinvestments.co.za

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