Do return figures lie?
You need to dig deeply to truly understand a fund’s performance.
As every prospectus and fact sheet warns you, past returns are no guarantee of future performance. We couldn’t agree more. When analysing a fund’s merit, we put more emphasis on its manager, strategy and expense structure because we think those factors are better predictors about how a fund is likely to perform in the future.
That said, we don’t ignore performance entirely. We need to understand the factors behind a fund’s performance to better assess a manager’s skill level, the effectiveness of the strategy, and the risks of the fund. However, when evaluating a fund’s returns, we are cognisant of the shortcomings of many of the common measures of performance.
Don't focus on the near-term
For example, a fund’s short-term performance doesn’t carry much weight in our analysis. It’s much harder to separate luck from skill over short-time spans, and short-term returns reveal very little about a fund’s merit or a manager’s skill.
The same can be said for calendar year returns. Calendar years are too short to provide a meaningful indication of a manager’s abilities. Any manager might be able to beat his category peers over a year or two, but very few can outperform over a full market cycle, which can span several years. Plus, calendar years are arbitrary divisions of time. Why should we place more weight on the time period from January through December than on the 12-month period between June and May just because our calendars happen to be organised that way?
Rather than falling prey to the “short-term-ism” that pervades much of the investment thinking these days, we think investors should focus on a fund’s long-term results. But that’s not always a straightforward task. There are occasions when long-term returns don’t tell the whole story. Let’s look at an example to illustrate why.
Use rolling returns for more detail
Consider two funds in the Morningstar US large-cap blend category--JPM America Large Cap and Investec American. (To read our analysis of both funds click here and here.) JPM America Large Cap generated an annualised loss of 4.3% over the five-year period ended March 31. Meanwhile, Investec American lost 5.8% per year over that same period (returns in USD). So by that measure, the JPM fund appears more successful.
However, the rolling returns tell a very different story. For the 25 rolling three-year periods over the past five years, the Investec fund outperformed its category average (Morningstar US large-cap growth) an impressive 20 times, or 80% of the time. But the JPM fund outperformed its category average (Morningstar US large-cap blend) only 10 times, or 40% of the time. Compared head to head, the Investec fund outperformed the JPM fund in 18 out of the 25 rolling three-year periods. So even though the JPM fund has produced better five-year returns than the Investec fund, the latter has outperformed more frequently.
What are we to make of these seemingly contradictory results? A closer look at the rolling returns gives us an important hint. The bulk of the JPM fund’s outperformance has come more recently, while the Investec fund had a tougher time of late. That’s not an uncommon story these days. This brutal bear market has marred many a fine long-term record. That’s because trailing long-term returns are end-period biased. In other words, a fund’s recent results can significantly impact trailing long-term returns, particularly if you are looking at period of less than 10 years. So if we just considered five-year trailing returns, we would overemphasise a relatively short time span of underperformance for the Investec fund and completely miss a long record of consistent outperformance.
Make sure you understand performance drivers
The above example shows why performance measurement needs to go beyond the obvious. Furthermore, we think the true benefit of performance analysis comes in understanding not so much how a fund has performed but why it has performed as it has.
To return to our example, the managers of the Investec fund invest with conviction; they run a compact portfolio of 40 to 50 stocks and are willing to make sizable sector bets. The fund’s top 10 holdings can consume as much as 40% of the portfolio. This sort of high conviction strategy will lead to periods of underperformance, as was the case in 2008, when several of the manager's top picks, including some in the financials and energy sectors, worked against it. We wouldn’t trust such a bold approach to just any investor, but the managers here are quite experienced and they have a long record of getting more calls right than wrong, both here and at their US domiciled fund.
The JPM fund’s performance is also consistent with its strategy. It restricts its view almost exclusively to the largest 200 U.S. stocks, as measured by market cap. These big industry leaders have weathered the recent storm better than their smaller competitors. But in past years, mega caps experienced a long stretch of underperformance, which partly explains this fund’s rather unimpressive rolling returns.
In sum, measuring a fund’s performance is not as simple as it might initially appear. It’s important to dig deeply into the data, and even more important to understand the factors behind performance.
