Staying the course ensures good returns on unit trust investments
• Investors who opt to get out of underperforming funds end up destroying long-term value
Investors may be tired of hearing the same old cautionary tale to “avoid a short-term view” or “ignore the market noise”. Yet there is good reason why asset managers insist on repeating this principle: all the data show that it is very harmful to take a shortterm view when making your investment decisions.
Trying to chase the bestperforming funds by switching to them based on their shortterm past performance is actually one of the best ways to destroy the long-term value of your portfolio. Equally damaging is selling a fund when it experiences short-term underperformance. Yet, unfortunately, this destructive behaviour is strikingly prevalent among South African investors.
The graph illustrates how investment flows are closely following the previous one-year relative performance of a typical conservative balanced fund over the past 10 years (one-year ranking depicted by the red line). It highlights how the fund’s short-term returns have driven the fund’s net investment flows in the subsequent quarters (depicted by the yellow bars).
Starting from 2006 we can see how the fund’s strong oneyear relative performance in 2005-06 (ranking high in the top quartile against its peer funds, in the top band of 0%25%) attracted positive net inflows in 2006-07, but these shrank and turned negative in 2008 after its 2007 performance fell off.
This effect is even more dramatic in the 2009-11 period: we see its very strong 2008-09 performance attract large inflows in 2009, only to reverse to net outflows in 2010-11 when the fund’s relative performance dropped off sharply into the bottom quartile of its category (75%-100%). And this pattern continues through the present.
Importantly, the data also demonstrate that the investment flows for this fund do not follow longer-term three- or five-year fund performance, despite its strong relative returns over these periods and out to 10 years (although this is not captured in the graph).
Yet for most funds these would be more appropriate periods on which to base investment decisions, as these longer periods would coincide with the investment horizon targeted by the fund’s manager.
The fund delivered excellent performance over most periods: those investors who stayed in it for the entire 10-year period would have received a return of 12.6% a year (after fees), making it one of the highest-ranked funds in its category.
Therefore, those who switched out during its underperformance would have received less than this.
Based on the continual flows into and out of the fund, the average investor actually experienced a return of 10.1% per annum (after fees), which is 2.5% per annum less than the fund return. While this differential may not seem like a lot, it means that investors who stuck with the fund during the downturns ended with an astounding 53% more than the average investor who switched in and out again over time.
Global unit trust industries consistently report this negative differential between the return experienced by investors, termed the “money-weighted” return and the fund, or “timeweighted” return, largely caused by investor-switching behaviour. This is beyond the impact of fees, which are already taken into account. In the US, for example, even passive funds experience this gap: over 10 years the SPDR S&P 500 ETF recorded a differential of about -3.4% a year.
In SA, a sample of 10 of the largest multiasset unit trust funds (representing R438bn in assets or 21% of total industry assets) had an average return differential of -3.5% a year over more than 16 years since their respective inceptions. This means that these funds returned nearly 70% more than what investors in those same funds actually achieved over the period — an example of how investors are destroying longterm value by reacting to shortterm performance and switching in and out of different funds.
It’s important for investors to remember that fund returns are cyclical (as depicted in the graph), since they reflect not only the financial and economic cycles of their underlying assets, but also the style of their fund managers.
Fund managers have perfected their investment processes over many years in order to overcome these cycles and deliver to each fund’s investment objective over its specified investment horizon.
Investment views that are implemented in funds take time to pay off, and this can, and often does, contribute to short-term underperformance before they actually do deliver. This is why most funds have recommended investment periods that investors should stick to.
While it can be uncomfortable staying in an underperforming fund, choosing a fund manager with a strong longterm track record can give investors more confidence.