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Rating Asset Managers – Qualitative then Quantitative
When we rate Asset Managers we have a strong preference for qualitative evidence. This is not to say that we completely ignore past fund returns and risk statistics (quants). Rather, it’s that we must first establish whether the past returns are a legitimate representation of the current team and approach. Then we can evaluate the track record, once it’s validated.
So, do teams and businesses change? Let’s take a look at “value” investors. This is a class of investors who request their clients take a long-term view because they may underperform for a substantial period before their investment thesis delivers. From such a group, we would expect the highest levels of team and business stability. We considered a list of SA managers who classify themselves as value, and noted that only 4 out of 11 have had no meaningful changes to either the team or the business ownership and structure. That means that the track records of 7 out of 11 funds need to be viewed with significant skepticism, especially those with team changes. The point we are making is that, even with long-term investors, things change. The past is not that reliable: people move and businesses change ownership.
Another challenge with a pure track record based assessment is whether fund managers’ performance does persist. Can you choose today’s winner based solely on their past returns? In an attempt to answer this, we considered the actual returns of the SA General Equity Sector through time. If a fund outperformed over the previous 5 years, the odds it outperformed over the next 1, 3, 5 and 10 years ranged from 11 per cent to 18 per cent. These are not great odds. Your odds are less than 1 in 5 of selecting a winner across all time frames, based purely on past results.
We can look at this data in many other ways too and it all points to the same problem: past performance is an incomplete guide. For example: if we go back to September 2008 and ask: of the funds that were quartile 1 and quartile 2 on 5 year rolling performance then, how many managed to stay in either the 1st or 2nd quartile five years later? The answer is 50 per cent. Put another way: there are 50 per cent odds that a fund ranked quartile 1 or 2 five years ago, would remain in quartile 1 or 2 five years later. Half the funds that were above average became below average. The odds are the same as a coin toss.
Now, consider the qualitative aspects that would make the track record more reliable (applicable to the current team and business). Which SA equity funds, over the past 5-10 years have had:
a) Continuity of fund managers and team?
b) Very little change to their business structure?
c) Very little change to their core focus (their products)?
d) The same investment approach?
Who would you come up with? Coronation? Foord? Investec Value Fund? Allan Gray? Certain Nedgroup Funds? But the list is not that long. These four questions set the bar really high.
So how do managers who rate highly on qualitative/consistency aspects fair in practice? To provide an indication, we considered the average quartile of fund performance on a five year rolling basis since September 2008, for each SA General Equity fund that has a five year history. For example, using Prudential Equity, between October 2008 and September 2013 it has averaged quartile 1 on a five-year rolling basis versus its peers. There were only 8 general equity funds that averaged quartile 1 over that period and the persistency of these funds is notable. As a general rule, these funds have been consistently managed within the same business structure and are names you would generally associate with team and business stability.
How would we conclude? Past performance in its raw form is a very poor predictor of future investment success. It is both a poor predictor of future out performance as well as a poor guide to peer relative success. However, where the fund manager has seen very little change to their business, team and process, their ability to repeat past results improves dramatically. This is why we spend our time on those factors that point towards consistency in the business and the team before we acknowledge any past results.