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Allow me to repeat myself

The problem with historical returns.

CAPE TOWN – One of the most often-repeated warnings when it comes to unit trust investing is that historical performance is not a guarantee of future returns. Every unit trust fact sheet even includes a line to that effect, just like every cigarette packet carries a cautionary about what smoking does to your health.

And yet I would be willing to bet every unit trust that I own that historical returns are still the most important gauge most financial advisors and individual investors use when choosing where to place their money.

It is part of our nature to be drawn to those funds that have delivered good returns in the past. Despite what we are told, we continue to believe that past success will translate into future success.

And, to be fair, this is not completely illogical. If a fund has a good track record over a number of years, it is reasonable to assume that, more or less, it will continue to perform in line with that.

Even if we are not foolish enough to believe that this year’s top unit trust must be the top unit trust again next year, we can still see patterns. And if a fund is consistently delivering good returns, then we assume it can continue that into the future.

However, if seeing that pattern is the totality of our analysis, we are opening ourselves up for trouble. Because every fund manager worth his or her job will tell you that returns are actually out of their control.

They do not know when the market will go up or down, and they certainly don’t know which stocks are going to run and which are going to tank. Hopefully they have well-developed instincts and processes to judge where the best opportunities are, but they do not and cannot know for sure if they will be right.

In fact, the fund manager you should be most comfortable with is the one that tells you after a very good run that he or she has been lucky. Because those are the fund managers that know that the market is more powerful than whatever clever ideas they may be using to select assets.

Which is all a bit of a roundabout way of saying that past performance is not a guarantee of future returns. What’s more important is how that return was arrived at.

In other words, what you really need to know when selecting a fund – and whether it’s a passive or active fund makes no difference – is what is ‘inside’ it. How does it generate performance, and what are the criteria it uses to decide where to invest?

One only has to take two highly talked-about local equity funds to make this clear – the Coronation Top 20 Fund and the PSG Equity Fund. Both have very strong track records over the last five and even ten years, yet their investment strategies are entirely different.

The returns generated by these respective funds have come in quite different ways. A wise investor will know this by having seen how their portfolios are structured, and looked at how they decide which stocks to hold.

Only once you have done that can you tell whether the fund you have chosen has an approach that you are comfortable with, suits your own investment philosophy, and ultimately will support you to what you want to achieve.

That’s the first part of it. But the second part is perhaps even more important.

Because a common mistake that far too many investors make is to judge returns over the short term and think that they can identify good or bad funds from that. They look at what funds have done over the last year and imagine that this tells them something useful.

It doesn’t. And hopefully the below example will provide a persuasive argument for why this is the case.

Back in 2008, not a single South African equity fund managed to earn a positive return. All of them lost money for their investors.

But some, obviously, did a lot worse than others. A few funds had a truly horrible year. The below table shows the worst 15 performers between January 1 2008 and December 31 2008.

SA equity funds performance 2008

Fund

Return

Stanlib Nationbuilder Fund

-48.84%

Stanlib Growth Fund

-39.40%

Stanlib SA Equity Fund

-38.91%

Sasfin MET Equity Fund

-36.23%

Stanlib Equity Fund

-34.85%

PSG Equity Fund

-33.15%

Old Mutual Albaraka Equity Fund

-32.73%

Stanlib Value Fund

-30.78%

Stewart Macro MET Equity FoF

-30.73%

Clarus MET Optimal Fund

-30.11%

Cannon MET Equity Fund

-29.19%

Investec Growth Fund

-27.95%

Stanlib Shari’ah Equity Fund

-27.86%

Harvard House BCI Equity Fund

-27.68%

Nedgroup Investments Growth Fund

-27.45%

Source: Morningstar

The very astute reader will have already raised his or her eyebrows at this point. Let me raise them further by providing another list.

The below table shows the top 20 performing South African funds over the last five years. Only those funds that were active in 2008 are included, so the Imara MET Equity Fund is not listed.

Top SA equity funds to 21 July 2014

Fund

5 Yr Return (annualised)

Foord Equity Fund

24.75%

PSG Equity Fund

23.25%

Sasfin MET Equity Fund

23.07%

Coronation Equity Fund

22.55%

Harvard House BCI Equity Fund

22.50%

Investec Active Quants Fund

21.86%

Coronation Top 20 Fund

21.30%

SIM General Equity Fund

21.08%

Marriot Dividend Growth Fund

21.08%

Stanlib Equity Fund

20.95%

Old Mutual Active Quant Equity Fund

20.93%

SIM Top Choice Equity Fund

20.51%

Prudential Equity Fund

20.33%

Gryphon All Share Tracker Fund

20.18%

Stanlib SA Equity Fund

20.11%

Old Mutual Investors Fund

20.08%

PSG Wealth Creator FoF

20.02%

Absa Large Cap Fund

19.91%

Prudential Dividend Maximiser Fund

19.87%

Stewart Macro MET Equity FoF

20.16%

Source: Morningstar

And here is the crux – six different funds appear on both lists. In other words, six of the worst performing funds in 2008 are amongst the best performing funds over the five years since then.

So the investor, who at the start of 2009 looked at a list of the previous year’s worst performing funds and disregarded them entirely, would have seriously reduced his or her chances of identifying the funds that were going to perform in the future.

Which makes this worth repeating: past performance is no guarantee of future returns.

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