Is your adviser relying on past performance when selecting funds?

PAST performance is no indication of future performance. This warning is drilled into investors’ heads at every opportunity by the investment industry.

Research by Standard & Poor’s in the United States backs this up: it found that, when assessed on performance, of the 687 unit trust funds in the top quartile (25%) in March 2012, only 26 of these, or 3.78%, were in the top quartile two years later.

However, it appears that South African financial advisers are using past performance as their number-one criterion in selecting funds for their clients.

Shaheed Mohamed, the product development manager at Allan Gray, recently conducted a survey among financial advisers in South Africa to identify the factors they consider when selecting unit trusts for their clients’ portfolios.

He found that, although advisers consider a variety of factors when choosing funds – including risk, investment styles and costs – a fund’s performance over the past five years topped the list. Performance over seven years or more also rated highly, with performance over three years slightly lower.

Overall, the factors rated by the respondents were, from highest to lowest: past absolute performance, past performance relative to the fund’s benchmark, risk measures (how risky or volatile a fund is using, among other statistical measures, standard deviation, maximum drawdown, and Sharpe and Sortino ratios), a manager’s investment style, how long the fund manager has managed the fund, costs, the source of information about the fund, the fund manager’s qualifications, the number of funds managed by a particular management company, the size of the fund, and the fund manager’s approach to responsible investing.

Mohamed sent his online questionnaire to more than 4 000 advisers, from whom he received 419 valid responses. Over half of the respondents had a university degree, half were accredited Certified Financial Planner professionals, and about 84% of them were independent. About 56% of the advisers had more than 10 years’ experience as a financial adviser.

Mohamed says in his report that records of money flowing into and out of unit trust funds (he used the Allan Gray Stable Fund as an example) show that investors tend to take their money out of a fund when it is performing badly and tend to buy into a fund when it is performing well.

This behaviour of “buying high and selling low” – as investors of individual stocks on the stock market are inclined to do – is the antithesis of wise investing, and it is what a professional financial adviser should be preventing you from doing.

To what extent they are successful in this cannot be ascertained from Mohamed’s research. But it does show that, whether the advisers are making the investment decisions or whether they are acting under pressure from their clients, past performance plays an important role in those decisions.

What did surprise Mohamed was the lower regard for relative performance against a benchmark, and that advisers were not more cognisant of how funds are managed differently according to their categories and their benchmarks.

For example, one multi-asset high-equity fund may have a composite benchmark made up partly of a share index and partly of a bond index, while another may have a benchmark of Consumer Price Index inflation plus five percentage points, giving their respective managers different targets to aim for.

Another important factor in fund selection, and one that is vital to bear in mind when considering switching out of a fund that is performing badly, is the fund manager’s investment style. These styles follow cycles that tend to be uncorrelated, so that while one style is performing well, another is under-performing. The adviser’s role here is to keep you invested through such cycles.

It was disappointing, Mohamed says, to see responsible investing, which takes into account environmental, social and governance (ESG) issues, come at the bottom of the list of selection criteria. He says ESG factors play a large role in the US when it comes to the marketing and uptake of investment products, and he expects the trend to gain traction here in South Africa.

If you are relying on your adviser to choose your investments, it is in your interests to know how he or she does so.

“Like fund managers, not all advisers are created equal,” Mohamed says. “Investors should ask advisers what process they follow when selecting unit trusts for their clients’ portfolios.”

martin.hesse@inl.co.za