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How to protect value in the long term

Investors may be tired of hearing the same old cautionary tale to “avoid a short-term view” or “ignore the market noise” when making investment decisions. 

Yet there is good reason why asset managers insist on repeating this principle: all the data shows that trying to chase the top-performing funds by switching into them based on their short-term 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, the data confirms that this destructive behaviour is strikingly prevalent among South African investors. 

The accompanying graph illustrates how local investment flows are closely following the previous one-year relative performance of a typical conservative balanced fund over the past 10 years. 

It highlights that the fund’s short-term returns have driven net investment flows in the subsequent quarters. 

Starting from 2006 we can see how the fund’s strong one-year 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 period from 2009 to 2011: 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. 

This pattern clearly continues through the present, with big swings in one-year performance soon mirrored by investment flows. 

Importantly, the data also confirms that the investment flows 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 these longer periods would be more appropriate timeframes on which to base investment decisions, as they would coincide with the investment horizon targeted by the fund’s manager. 

In fact, 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% per annum (after fees), making it one of the highest-ranked funds in its category. 

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, investors who stuck with the fund during the downturns ended with an astounding 53% more than the average client who switched in and out again over time. 

Unit trust industries around the world consistently report this negative differential between the return experienced by investors, termed the “money-weighted” return, and the fund (or “time-weighted”) return, largely caused by investor switching behaviour. 

This is beyond the impact of fees, which are already taken into account. 

In SA, a sample of 10 of the largest multi-asset unit trust funds (representing R438bn in assets or 21% of total industry assets) had an average return differential of -3.5% per annum over more than 16 years since their respective inceptions.

This means that these funds returned nearly 70% more than what the average investor in those same funds actually enjoyed over the period – a powerful example of how investors are destroying long-term value by reacting to short-term 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 like Prudential 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 long-term track record can give investors more confidence, and a financial adviser can also help ensure you stay the course. 

Pieter Hugo is the managing director of Prudential Unit Trusts.

This article is part of the December 2017 FundFocus survey, which appeared in the 30 November edition of finweek. Buy and download the magazine here.

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