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Unit trusts – who checks those doing the rankings?

By Candice Paine

The world is not an egalitarian place. Everything is measured and compared whether explicitly or implicitly. I can barely think of a decision which is not made on a relative basis and yet not all relative decisions are necessarily mathematically fair. Much of what happens in decision making is based on gut which comes from your upbringing; your education; your knowledge of a subject; who you are. Malcolm Gladwell wrote an entire book on this very phenomena. It is called “Blink” and well worth a read.

So, should we be ranking funds? Of course we should. Financial goals won’t be met by investing in a fund with the nicest sounding name or the prettiest marketing. A fund needs to deliver what you need it to and in an investing world of mostly uncertainty, the more time you spend analysing an option versus another one, the better your chances of your goals being met.

However as in life so in investing. Nothing is certain and passed performance is no indication of what will happen in the future. Ranking funds is ALL based on what has transpired in the past. This doesn’t mean we should ignore rankings. We need to understand them and particularly what they aren’t able to measure.

In South Africa our retail unit trust funds are ranked and applauded by two very prestigious awards viz. Morningstar Fund Awards and the PlexCrown Ratings. Both of these studies are eagerly anticipated each year and many a fund is invested in based on the outcomes.

So what is the essence of each measurement? Morningstar Fund Awards Methodology’s stated objective is to “recognise those funds and fund groups that have added the most value within the context of a relevant peer group”. Emphasis is firmly on one year performance numbers where risk and return figures for one year count for 48% each of the score tapering to an 8% weighting for the 5th year. Funds which have not adhered to Morningstar’s reporting requirements (which are not FSB requirements) are excluded from the universe as well as 10% of the smallest funds in a category.

Candice Paine, CFA, Strategist and consultant tackles the question of whether we should be ranking various unit trust funds.

There is a perfunctory qualitative overlay carried out by Morningstar analysts which may see more funds excluded from a peer group PlexCrown Ratings used for the prestigious Raging Bull Awards. It uses 5 different risk metrics and have tried very hard to make sure that the ‘crowns’ they award a fund actually have some real world meaning. The metrics used try to rank risk-adjusted returns and actual manager skill.

PlexCrown’s exclude index tracking funds as they state that tracking an index doesn’t require any skill. This isn’t exactly true and there is also a very valid debate around which indices are tracked and why; how much of a portfolio managers returns come from the market and how much from skill? Moving into the multi-asset class fund space also allows a passive fund to compete with an active manager in terms of initial strategic asset allocation and stock selection especially if smart beta portfolios are used. But this is a discussion for another time.

Suffice to say that both measures have drawbacks. If you understand what they aren’t able to measure qualitatively, using the outputs becomes far more meaningful as a guide to picking a fund which will meet your needs. Broadly speaking, both measures rank funds with similar mandates (essentially funds in each of the ASISA categories) on a risk vs return basis weighting the outcomes variously over a longer and shorter time frame.

What the rankings aren’t able to capture is arguably more important. Drivers of fund performance are numerous and manager skill diverse. Broadly speaking, the South African equity market is driven by at least three factors viz. value, momentum and the broad market. A fund manager who was exposed to one of these factors when they were the major driver of market performance is not necessarily displaying skill.

So the first hurdle to comparisons is the benchmark. A fund manager is pitted against a benchmark which is probably flawed e.g. is the FTSE/JSE All-share index really representative of the fastest growing companies and industries in South Africa. And if not, should an equity manager be trying to outperform the SWIX or the CAPI instead? Questions like what drives returns over the longer term? Is it earnings growth or reinvested dividends? Would we be able to measure these outcomes in the five year periods which our most notable rankers use?

Asset allocation funds are even more tricky as there isn’t a standard industry benchmark for them. Does this mean they’re all aiming for the same goal? Which asset class drove performance over time? We know equities give superior returns in the longer term so if a fund manager was overweight equities is that demonstrating skill or was he/she reckless in taking on too much risk?

Relatively speaking of course.

What all rankings are trying to do is to determine if a manager has enough skill to deliver what they say they’re going to deliver and how much risk they take on to do this. In order to really determine this, all funds in a universe would need to have an identical, (investable) benchmark, mandate and investable universe. Then over a period of time, you could determine which fund manager had demonstrated the most skill as performance drivers would be identical. You could strip out what was beta (general market movements) and what represents alpha. This is the closest you will come to comparing apples with apples. You probably may never be able to determine what was just pure luck unless the manager confesses.

So back to our rankings and whether we should be taking any heed of them. The short answer is yes.

They definitely alert investors to funds which may be worth looking at more closely. They certainly won’t tell you which fund will be the next top performer or whether your financial goals will be met by backing a certain investment house, but they give you a sense of who has done well in the truncated past. You will still need to do your own due diligence focusing on processes, philosophy and the people running the fund you may like to invest in.

But as in life, nothing is certain in investing either. Rankings are merely one more tool to help you on your way.

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