Written by: Pieter Hugo, MD Prudential Unit Trusts.
Question:
My friend has told me about some hot funds that have been performing really well recently, with double-digit returns. Isn’t it a good idea to include these funds in my portfolio?
Answer:
It’s certainly true that the latest hot investment ideas are popular topics when you get together with friends at the weekend. But what should be even more important to share around the braai or dinner table is the surprising fact that chasing last-year’s winners definitely doesn’t pay off over time.
Graph 1 shows the relatively lower investment growth that would have been achieved by a “performance-chasing” portfolio in the South African market over the past 10 years to 31 December 2016.
The gold line depicts a portfolio where, at the beginning of every year, the investor switched into the fund that had the best absolute return over the preceding three-year period in the ASISA South African Multi-Asset High Equity category (typical “balanced funds”). For comparison, the red line shows the growth of an investment in the Prudential Balanced Fund over the full 10-year period, while the black line shows a portfolio where, at the beginning of every year, the investor switched into the balanced fund that had the worst absolute return over the preceding three-year period.
We can see that the investor would have been worst off in the performance-chasing portfolio, while they would have been significantly better off had they adopted a “buy-and-hold” strategy and remained consistently invested in the Prudential Balanced Fund for the full 10-year term. Interestingly, the strategy of switching into the worst performing fund at the beginning of each year also delivered a better return than switching into the best performing fund.
Additionally, it’s worth noting that the growth of the performance-chasing portfolio ignores any potential fees and taxes incurred when switching between funds, which would have further decreased the overall return. Unfortunately we can demonstrate that this damaging short-term performance-chasing behaviour does dominate the investment flows into and out of South African unit trusts.
Graph 2 illustrates how the previous one-year performance of a popular and highly regarded fund in the ASISA Multi-Asset Low Equity category over the past 10 years (depicted by the black dots) has driven the fund’s subsequent net flows (depicted by the red bars). Starting from 2006 we can see how the fund’s strong short-term (12-month) relative performance in 2005-06 (ranking in the top quartile of its peer funds, in the top band of 75%-100%) attracted positive net inflows in 2006-07, but these shrank in 2008 after its 2007 performance fell off somewhat. This effect is even more dramatic in the 2008-11 period: we see its very strong 2008 performance attract large inflows in 2009, only to reverse to net outflows in both 2010-11 when the fund’s relative performance dropped off sharply in 2009-10. And this pattern continues through 2016. Importantly, the data also demonstrate that investment flows do not follow longer-term three- or five-year fund performance (although this is not captured in the graph).
In fact, the fund delivered excellent long-term performance, to the benefit of investors who stayed with it for the entire period. Therefore those who switched out during its underperformance would have missed out on this, destroying long-term value. It’s important to remember that a fund
or asset manager isn’t suddenly considered to be poor after one, or even two, years of underperformance. Investment views that are implemented in funds take time to pay off, and this can lead to short-term underperformance before they actually do deliver what they promise. Most funds have recommended investment periods that investors should stick to.
So we can see that investors are in fact relying on very short-term performance far too much in their choice of funds and fund managers. To make this choice, you need first to determine your investment goals and timeframe for investing, as well as your risk tolerance, preferably working together with a financial adviser. Then identify asset managers and their funds that have solid, long-term track records that prove they are able to deliver consistently to these goals, ensuring that you have a well-diversified portfolio. While this may include last-year’s top performing fund, performance should certainly not be the only criteria; and definitely not short-term performance. Also consider the asset manager’s reputation, longevity of its team of experts, and the fees involved, among other factors.
Lastly, you should stick with these funds over time, since all investments experience periods of underperformance and over-performance in line with financial market cycles. Switching should be done only if and when your goals or financial circumstances change. Of course, accepting that your portfolio will underperform from time to time can be difficult, which is where a financial adviser can help ensure you stay the course.