For three of the last six years, the Coronation Top 20 Fund has underperformed the FTSE/JSE Shareholder Weighted (Swix) All Share Index. In two of those periods, it delivered a negative return over a time when the market was up.
|Coronation Top 20 Fund 12-month relative returns|
|FTSE/JSE Swix All Share Index||17.98%||6.07%||9.04%||7.00%||0.86%||0.19%|
|Coronation Top 20 Fund||9.62%||2.74%||14.94%||9.55%||3.80%||2.39%|
However, viewed over the past 15-year period, the Coronation Top 20 Fund is the best performing South African general equity unit trust. It is one of only 11 funds to have outperformed the Swix index over this time.
|Coronation Top 20 Fund 15-year annualised return|
|FTSE/JSE Swix All Share Index||14.4%|
|Coronation Top 20 Fund||15.7%|
In research published last year, Morningstar found that this kind of return profile is hardly unique. In fact, Morningstar found that funds that outperform their benchmark over 15 years will underperform that benchmark for an average of nine to 12 years within that period.
Conversely, funds that underperform over a full 15 years could go through periods of outperformance of as long as 11 years during that time.
“The main implication of these findings is that standard performance-measurement periods, such as three, five, or even 10 years, are far too short to evaluate a manager with confidence,” the authors of the Morningstar study noted.
The Coronation Top 20 Fund is again a good example. Over the past decade as a whole, the fund has underperformed its own benchmark – the FTSE/JSE Capped All Share Index. Yet, longer term, it is the best equity fund in the country.
It’s not all one way
This highlights how difficult it is to identify ‘good’ funds. Most investors are under the impression that at least a five-year historical return, and certainly a 10-year historical return, is illustrative of a fund’s future prospects. However, the Morningstar study shows that this isn’t the case, because just a few extremely good years can outweigh long periods of weakness.
“Long-term outperformance is driven by a handful of periodic outsized years accompanied by relatively long periods of underperformance,” says C Thomas Howard, the CEO and chief investment officer at AthenaInvest, based in Colorado in the US.
“Investors that want to outperform in the long run need to be prepared to accept substantial periods of underperformance.”
Consider another of the best long-term performers in South Africa – the Prudential Dividend Maximiser Fund. The table below illustrates its year-by-year performance between October 2009 and September 2016:
|Prudential Dividend Maximiser Fund 12-month relative returns|
|FTSE/JSE Swix All Share Index||21.79%||4.14%||26.96%||25.28%||17.98%||6.07%||9.04%|
|Prudential Dividend Maximiser Fund||18.65%||3.81%||23.48%||28.25%||16.82%||2.78%||5.97%|
For six of these seven years, it underperformed. In fact, for seven of the past 10 years, the fund has delivered a return below the benchmark. Yet over 15 years, it is the eighth best equity fund in the country.
The urge to act
The obvious challenge for investors when considering this kind of return profile is that extended periods of underperformance are deeply uncomfortable. And the longer they persist, the more likely they are to lead to investors selling out and opting for a fund that has shown recent outperformance.
As humans are naturally loss-averse, this is understandable. However, the risk is that investors then make what should be a long-term decision based on short-term information. As the Morningstar study shows, judging fund returns over even 10 years can be misleading.
Staying invested is, however, extremely difficult. This is not just because investors fear that the underperformance will continue, but because it is unsettling to feel like there is nothing you can do about it.
“Investors perceive short-term underperformance as a problem that needs to be ‘fixed’,” Howard points out. “Doing something gives them a false sense of control. They blame the manager for inevitable ups and downs and fire them, falling prey to the fallacy of control.
“Done repeatedly, this is sure a recipe for continual underperformance,” he says.
Put another way, investors struggle to accept that once they have chosen a fund manager they have handed over control of their money. Performance is therefore out of their hands.
This emphasises the importance of selecting the right fund manager in the first place.
If even 10 years of underperformance can be reversed by a few years of strong outperformance, that suggests that there is no value in trying to shift money between funds at any point based on their historical returns alone. In fact, numerous studies have proven how chasing performance destroys value for investors.
The far better approach is to get your asset allocation and manager selection right from the start. Understand and be comfortable with the investment strategies that your chosen fund managers will follow, and, most important, be willing to accept that periods – and occasionally extended periods – of underperformance are inevitable.
“Active investing is a long game. It is routine for a good manager to trail an index for years,” the authors of the Morningstar study noted. “It turns out that even if you have the acumen to pick a good manager, this may be of little avail if your patience fails you.”