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This is how difficult it has been for local equity managers

The risk and reward numbers tell a story.
A continuation of the slightly stronger market returns of 2019 should give managers the opportunity to turn things around. Image: Shutterstock

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.

Read: Are you buying what active managers are selling?

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.

Read: Gold, oil soar, shares slip as US and Iran trade threats

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.

Source: Investopedia

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.

Read: Don’t let the markets fool you

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A demanding environment for active managers? Is it not always thus?

Active managers struggle in bull markets, they struggle when markets move sideways or downwards. They struggle when stocks move in unison, they struggle when performance is concentrated in a few stocks or sectors. They struggle when volatility is low, they struggle when volatility is high.

It appears, they just always struggle.

A better indicator is Sortino Ratio in my opinion.

This article should include those fund managers or fund managers information ratio that is widely available. It would give a good indication of who adds value and who are in it for the fees. The asset management game is also a perception game…the story can be better than your numbers and a viable business van be built.

Most sa fund managers are closer bench mark trackers and their fortunes are linked to the ebb and flow of the underlying index. There are a few fund managers who run contrarian and larger tracking errors that allows for differentiation of returns. The reality is that poor SA returns are here to stay.. many headwinds and structural deterrents to Sa. There are a few valuation dislocation and oppurtunities to make money but largely you should avoid buying the SA market in general.

….so true, especially the first sentence. Active managers today just “shadow” the ETF index’s and charge handsomely

Name one fund manager who is doing this?

“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.”

You don’t or should not pay fund managers to make a loss.

Fund Managers are waist of money like financial planners, they don’t bring anything of substance to the table. The Financial planner will tell you to invest with the investment company who gives them the most commission regardless if he is an independent financial planner or not and fund managers will take most of their money they earn and put it in property. Everyone works for their own pocket.

Ask your Fund Manager what percentage of their own personal wealth to they invest where they invest their clients wealth. Do they invest 0%, 10% or 90% of their wealth where they invest their clients money.

Fund Managers get rich from fees, not from good performance on the stock market. They make money when the market is going up, anyone can do that.

My experience to date is that a majority financial planners don’t have an idea what the sharpe ratio is; neither how it is calculated and a standard deviation is. Their approach first look at their own interest and how the investor can contribute to progress this.
So, if difficult for fund managers, surely the more for financial planners. The profile for financial planners and fund managers needs serious changes. Too many sales agents practicing in a field where they should not be because of technical constraints

True, everyone works for their own pocket. I work in investment banking.
What doesn’t come out in the media is how they bad mouth their clients behind their backs.

The financial industry is a business looking how they can make more fees, they are not their for your financial well being.

The Financial industry is a business with fat cats milking wherever they can. I have worked in the financial industry.

90% of fund managers won’t beat the market and for a period of more than 10 years the amount of fund managers in the world that will beat the market you could count on one hand.

A good Exchange Traded Fund with low fees is the best for the individual investor. In the US you get Exchange Traded Funds with yearly management fees of only 0.04%.

Fees and Tax hurt any investment. A person should invest tax free in an Exchange Traded Fund.

Financial Fees in South Africa are still too high.

ETFs will always beat fund managers, unless by some freaky serendipitous accident.
To compound arrogance, FMs charge exorbitant rates for never having clients’ interests in mind.

‘ETFs will always beat fund managers’. Please explain this statement as it makes no sense to me?

End of comments.

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