Long and winding or straight and safe?
All roads eventually lead to Rome, but it’s important for investors to decide whether they prefer a riskier or safer route to reaching their investment goals.
accordingto scientists, it is a fact that no two snowflakes look alike. Of course, we can also apply this finding to people in that no two people are alike.
We recently took a family road trip through the Little Karoo. Aside from being one of the most beautiful places on earth, it is also well-known for some of the world’s most breathtaking mountain ranges. We spent the night in Prince Albert with Oudtshoorn as our next destination. We had a choice between two routes to get there: a longer but faster route via Meiringspoort, or a shorter but slower route over the Swartberg Pass. Despite my wife’s fear of heights, our daughters convinced us to take the Swartberg Pass. I’m not going to discuss in detail the amazing scenery and technical driving skills needed, but I did realise that although we reached our destination safely, some found the journey mindblowing and fun, while others were extremely frightened by it.
These emotions do not only apply to people who climb mountains or jump from aeroplanes, it also applies to individuals who face the task of deciding which investment to choose. Let’s take two different equity fund managers: The first (Fund A, see graph) doesn’t care about the performance of other shares. They have a specific strategy, they stick to it and they believe that they will get investors to their investment destinations safely.
For the second fund manager (Fund B), it is important to remain within the confines of something like the FTSE/ JSE All Share Index and they correlate their returns much closer to the returns delivered by the index itself. Both these funds happen to be General Equity Unit Trusts, both have a fund value of at least R5bn, and more importantly, both managed to outperform the FTSE/JSE All Share Index on a total proceeds basis over the last 10 years – an achievement that only 29% of funds with a 10-year history in this sector can boast with. The difference between these two funds, however, is that Fund A not only underperformed at times when compared to the index, but it even delivered exceptionally negative returns while the index performed positively. Does this make Fund A the wrong choice, or a worse choice than Fund B? Not at all. All it shows us is that although both fund managers are clearly very skilled, as in the case with the Swartberg Pass and my wife’s fear of heights, some investors simply won’t be able to tolerate the risks as well as others.
The better question is how I can best prepare myself before choosing a specific investment. Do I choose the riskier investment route that leads over the Swartberg Pass, or do I choose the straighter, safer option in a situation where both funds offer a very impressive profit track record?
For me, the answer lies in the tracking error. The financial term for this ratio is defined as: “the divergence between the price behaviour of a position or a portfolio and the price behaviour of a benchmark” (Source: Investopedia). This deviation is usually expressed as a percentage. Based on historical data, the higher the percentage, the higher the variance in relation to the relevant benchmark may be. Let’s again take the local General Equity Unit Trusts as an example: these funds’ two-year average tracking error currently stands at 6.5%, which means that these funds can either outperform or underperform compared to the FTSE/JSE All Share Index over any 12-month period.
If large underperformances compared to something like the FTSE/JSE All Share Index leave you feeling uncomfortable, rather choose funds or investments with the help of a skilled quantitative and qualitative researcher with a ratio of 5% or lower. For those who are less concerned with the returns delivered by an index and who prefer to buy into the management of the fund, Fund B’s tracking error of nearly 19% won’t matter.
Although all roads lead to Rome in the sense that investors would all generally like to reach the same investment goals, it is extremely important to decide on the route you need to take to reach your goals, so that you can prepare yourself for the journey to the best of your abilities.
Do I choose the riskier investment route that leads over the Swartberg Pass, or do I choose the straighter, safer option in a situation where both funds offer a very impressive profit track record?