Looking ahead

We have all heard the warning that past performance is no indication of future performance.

I am not so sure. Of course it is no guarantee, and it would be absurd to expect good performance to repeat precisely over short periods such as a month or a quarter. But just as some advocates, architects or musicians are better than others, fund managers can show more skill. And as investment is a team sport, the quality of the house culture is equally important.

I have heard anecdotal reports, usually from poor-performing managers, about how it is better to keep switching to the worst unit trust rather than the best. And there are certainly inflection points when, for example, John Biccard’s Investec Value Fund flipped from the bottom to the top of the table.

Now Morningstar has produced a paper, based on North American and European-based funds, looking at the extent to which its analyst ratings have predicted future performance — the best prospects are expected to come from “gold” funds, then “silver” and “bronze”, down to “neutral” and “negative”. It is a much more balanced and sane system than Morningstar’s star system, which looks purely at past performance.

The funds were assessed using two heavyweight but reputable techniques: the Fama-macbeth regressions (with no witches to stir the pot, unfortunately) and the event study framework. In equity funds, gold funds outperformed over five years, with bronze ahead of silver. Those who adopted the strategy of investing in the worst performers would have had a return at least 10 percentage points below the gold medal funds. Gold, silver and bronze were also well ahead of negative funds in asset allocation. The main anomaly was that in the fixed income category, silver funds were far ahead of gold — but all the medallist fund classes were well ahead of the neutral and negative funds.

The Morningstar Analyst Rating does not take a crudely mechanistic approach. It is compiled by people, not machines, and it’s clear Morningstar’s experts have worked hard at acquiring insights into the sustainable advantages of each fund. It looks at factors such as expenses and the ownership of fund shares, which are often ignored in favour of past performance.

Backward-looking system

Morningstar has five pillars: process, performance, people, parent and price.

When it comes to parent, it prefers a hands-off parent as it prefers stewardship to salesmanship, and it likes a firm which knows how to retain talent — not always easy when the parent is a bank or a life office. Increasingly, investors also recognise the importance of price, and the value that a fund can destroy compared with cheaper alternatives.

Let’s hope the analyst rating system will be rolled out comprehensively in SA soon. True, the star system is here — but who wants a backward-looking system focused on past performance? Maybe it is some use in picking funds for the next five years, but it only adds to the confusion over shorter periods.

Fund managers will hate Morningstar’s findings. But it’s still possible for experienced manager research teams to select funds which, over an economic cycle, are likely to outperform the index. Just don’t judge them on one-year performance.

There’s a good reason why Allan Gray, Investec and Coronation are so dominant in the pension fund space. They have a lot of skill, and I suspect they will all do well in the SA edition of the Morningstar Analyst Rating.

Factors such as expenses and the ownership of fund shares are often ignored in favour of past performance