Market conditions are a great determinant of whether or not fund managers add value over and above the returns earned by an index. One of the arguments in favour of investing in index funds is that the average active fund manager will not really add significant value over market returns in the average year. I have yet to experience what an average year in the equity markets feels like.
An argument for active management, on the other hand, is that the equity market is inefficient and that a smart manager can exploit these inefficiencies over time and give you additional returns that you would not get from the All Share index (Alsi). An active manager can also introduce either more or less risk into the portfolio by selecting a particular mix of shares.
Common sense would indicate that most active fund managers struggle to beat the market, either when the market is very strong (perhaps because they struggle to get fully invested and stay that way as cash flows in) or when resources shares out-perform the market. This could be because most stock pickers experience a level of discomfort at putting large portions of a portfolio into a sector so driven by macro-economic factors and where price volatility is high.
Let's look at the numbers. I have used the bid-to-bid price total returns provided by Micropal. A quick glance at general equity unit trusts in 2004 shows that the average fund manager added a whopping 13 percent to the returns of the Alsi. Out of the 43 general equity unit trusts, all but the lowest few (most of which were index trackers and so were doing their job by matching market returns) beat the market. Investors achieved good returns and managers earned good performance fees. Stars were born.
This year is different
So far this year, it is a very different story. Up to the end of September, the average manager has lagged the equity market by nearly 10 percentage points. Only one manager is actually beating the Alsi for the year to date.
In scrutinising the performance tables, I discovered another fascinating pattern. It seems that most of the general equity fund managers who did exceptionally well last year are lagging this year and vice versa. There are a few consistent performers, but the ranking of most active (non-index-tracking) managers this year bears little resemblance to that of last year.
The topic of consistency in returns is a complex and fascinating one, and I do not regard my comment about the difference between returns in 2004 and 2005 as conclusive, but it is a startling observation nonetheless.
If you then combine the returns for last year and this year to date, you will find that the massive out-performance of last year has carried the average manager through 2005, so that the average general equity manager is beating the market by four percentage points over the period - a much more sensible expectation. Twenty-nine out of 46 managers have beaten the market over this period - also a more realistic picture. Short-term observations can give a very misleading picture. However, there are only a handful of general equity unit trust funds with a performance history of 20 years or more. Looking over the longer term as well as the past five to 10 years, it is clear that managers struggle to keep up with the market when resources shares do well.
What you should do
What can we learn from these observations? Firstly, don't expect the average active manager to beat the index by more than a few percent a year over time. The 13 percent out-performance of last year is not a common occurrence.
Secondly, before you judge active managers during a period when resources shares performed strongly, ask yourself if you would have been comfortable having a full weighting in resources, given their volatility. Also it is most challenging for South African managers to beat the market when resources are doing well, and you should bear this in mind before you make a change to your portfolio based purely on past performance.
Finally, the 2004/5 picture is another example of the dangers of chasing the best-performing manager of the previous year.
Sure, you could have picked the few who performed well over both periods, but you were most likely to have moved from one lagging manager into another lagging manager, diluting your returns for the two years combined.
Looking at the general equity unit trust performance figures again, if you moved from the fund ranked number 30 for 2004 to the fund ranked number three for last December, you got a total return of 67 percent for the combined period, as opposed to 75 percent (which, incidentally, is the average for the combined period) had you stayed with the lagging manager. This is because the fund ranked 30th for last year is ranked 11th for 2005 to date, and the fund ranked third for last year is ranked 41st for 2005 to date (out of more than 40 funds)!
Don't make past performance the sole basis on which you choose a fund. There are still a few months left in 2005, but it looks highly unlikely the average general equity unit trust manager is going to beat the Alsi this year.