Choosing an active fund manager is a tricky task. Given that future outcomes can never be guaranteed, any investor is taking on risk when they put their money into an actively managed unit trust.
Assessing whether or not you have made a good choice might seem somewhat easier. The usual way to do this is to look at past performance and measure funds both against each other, and against the market. What investors want to see from an equity unit trust is that it has been able to beat a benchmark like the FTSE/JSE All Share Index (Alsi).
This is, after all, what most active managers will tell you they are trying to do – to produce returns in excess of what you could achieve by investing in a broad market index tracker. With a few exceptions, that is their value proposition.
This sounds simple, but is extremely difficult to do.
According to the latest figures from Morningstar, only 18 actively managed general equity funds have beaten the top-performing Alsi index tracker over the past three years.
Admittedly, this has been a demanding environment for fund managers. Most of the market has been moving backwards or sideways. Where gains have been made, they have only been from a few stocks, or isolated sectors.
That makes it very difficult for anyone to build well-diversified portfolios that manage risk and are still able to outperform. The successes are few, and the margins for error large.
Assessing both risk and reward
There is, however, another way to assess the historical performance of a fund manager. That is not by looking at return in isolation, but by considering whether, as an investor, you are getting adequately rewarded for the risk they are taking.
In the stock market, you are always taking some degree of risk. Share prices are volatile, there is always the chance of a Steinhoff-like collapse, and stocks can be impacted by outside events that actually have nothing to do with them at all.
For example, the US assassination of an Iranian general was good for Sasol’s share price, and boosted gold stocks, but was bad for just about everything else. Uncertainty around what might happen in the Middle East made investors nervous and so they looked for safer options.
The challenge for a fund manager is to manage all of these things in a diversified portfolio so that, despite these risks, the investor still benefits. One way of measuring how well they do that is by using the Sharpe ratio, which was developed by Nobel laureate William Sharpe.
Asking more questions
This is a fairly simple formula that first looks at how much return an investment was able to deliver above the return from government bonds. The reason for this is that government bonds are considered ‘risk-free’ (even though they aren’t entirely), so any investor not wanting to take much risk could safely earn whatever return they are offering.
If you are going to take more risk, it therefore stands to reason that you should get a higher reward. That is what you are paying a fund manager to achieve.
Sharpe’s formula then divides this difference by the volatility of the investment. This is used as a proxy for risk, effectively asking the question: how much risk did the fund manager have to take in order to deliver the excess return.
As a starting point, an investor wants to see a positive Sharpe ratio. That at least indicates that the fund was able to produce a return higher than what could have been achieved from government bonds.
A good outcome, however, requires a Sharpe ratio of more than one. That shows that the fund manager has delivered more than one ‘unit’ of performance for every ‘unit’ of risk taken.
The struggle for local managers
Among local equity funds, not a single fund has managed to do that over the last three years. According to Morningstar, the best Sharpe ratio achieved by any South African general equity fund since 2017 is 0.28. In total, only 11 active equity funds have a positive Sharpe ratio over this period.
Firstly, this indicates how few local equity funds were able to beat the return delivered by government bonds in the last three years. Secondly, it suggests that even those that did were unable to find enough excess return to be fully rewarded for the added risk they were taking.
This shows just how tough it has been on the JSE. By this measure, no local fund manager has been unable to extract real value out of the market.
This is a highly unusual set of circumstances, but it is a short term picture. A continuation of the slightly stronger market returns of 2019 should give managers the opportunity to turn this around and deliver better risk and reward outcomes for investors.