RONÉ SWANEPOEL: Jumping from one top-performing fund to another is a losing strategy

To quote the legendary Warren Buffett: “The investor of today does not profit from yesterday’s growth.”

Though we have all heard the disclaimers on investment advertisements that past performance should not be seen as an indication of future returns, many investors still switch to the latest hot offerings just before the inevitable slump in performance.

The start of the new year was volatile and uncertain, leading to a buying and selling market busier than in previous years. This is to be expected and human nature at times of volatile returns when global worries and geopolitical tensions investors seek out previous winners and include these performers, hoping for the same outcomes as in the past — or better.

The first thing investors tend to do when looking for a place to invest is to find a fund, company or sector that did well recently. To quote Carl Richards: “If you are going to hire a contractor to remodel your kitchen it would be reasonable to go look at the work they have done in the past and expect that quality of work to continue, if not improve.”

This is true of remodelling, but when in investing it is not always the case. Past performance should not be seen as an indication of future returns, especially not in the short term. Investments move in cycles. Winners now may not be winners of the future. S&P Dow Jones’s six-monthly “persistence scorecard” measuring the consistency of active funds shows that relatively few funds stay consistently at the top.

Let’s look at local market statistics, starting with the most successful Asisa SA general equity funds. Nineteen funds landed in the top quartile of their peer group in the 10 years to end-February (it considers only funds with a 10-year track record, excluding fund of funds). Of these 19, how many landed in their Asisa category’s top quartile three years running at some point in those 10 years, and how often did they pull off a “three-peat” (three instances of three-year successive first-quartile performance annually)?

Of the 19 funds (in the first quartile over 10 years), only seven performed in the top quartile for three successive years over the 10 years; only three  achieve this twice; and only one achieved a “three-peat”.

Other findings include:

• Nine of the 19 funds spent at least one year (of the 10) in the fourth quartile.
• Every fund spent at least one year of the 10 in the third quartile.
• Altogether 18 of the funds spent more than two years in the third quartile (over the 10 years).
• The 19 funds spent only about 30% (of the total instances over the 10 years) in the first quartile.

What be concluded from these statistics? Performance chasing rarely works. It is more important to look at a manager’s consistency in the longer term.

Morningstar conducted research into this area of investor returns and created a hypothetical performance chaser portfolio, which tracks investors switching investments into the best performing fund from the previous year at the start of each calendar year. This means an investor sells the fund they are invested in every year, ranks all the funds in the category from best to worst over one year, and switches their entire investment to the fund that has done the best over the last year. This is then compared with a portfolio managed by Morningstar — the Morningstar SA Multi-Asset High Equity portfolio (Morningstar Adventurous Portfolio).

The research aims to illustrate, through comparison, the returns achieved by the performance chasers vs the returns achieved by investors that remained invested in their portfolios over the same time frame. The Morningstar high equity portfolio returned 58% (cumulative) more than the performance chaser portfolio over more than eight years. An investor with an investment of R1m who stayed the course (and remained invested in the Morningstar high equity portfolio) would have gained an extra R578,975 in returns over the eight years.

The above scenario highlights clearly the benefits of staying invested in a robust and consistent strategy, as opposed to backtracking and chasing yesterday’s winners.

Possible reasons for underperformance of yesterday’s winners are:

• The selected funds’ good ideas have all paid off and the returns have been realise.
• They may have had an aggressive view that played out in their favour. It’s unlikely that the view will continue for the foreseeable future and could be at the top of the return cycle when an investor invests in the fund.
  
• This view could have been pure luck and not a manager’s solid investment thesis. For example, the fund could have been underweight offshore and then the rand strengthened due to a global risk on trade.

Implications for investors are:

• Returns don’t happen in straight lines and seldom occur when one expects them to.
• The long term is just a collection of short runs. Having a long-term strategy does not excuse you from short-term setbacks in markets and funds.
• It is vital to take emotion out of an investment portfolio. Often the most beleaguered investments turn out to be great opportunities for future returns, as investors can access these investments at a good price.
• Volatility creates opportunity. Short-term underperformance can translate into a solid, longer-term upside.

Trying to chase performance can be extremely harmful to an investor’s returns over the long term. It’s rare (if not impossible), even for professionals, to consistently time investment in and out of the market over time. One needs to consider the costs of trading funds, which is likely to make matters worse.

A well-diversified portfolio that is designed to meet your investment goals while remaining within your risk tolerance is a far better solution, and much likelier to result in long-term investment success than trying to buy yesterday’s winners.

Investing is a marathon, not a sprint. When it comes to investing, patience is rewarded. Time in the market remains superior to timing the market.

• Swanepoel is business development manager at Morningstar Investment Management SA.