By Francis Marais, 1 February 2017
For instance, when given shorter-term performance figures of bonds and equities investors tend to choose more conservative type portfolios, i.e. they choose more bonds than equities. However, when given longer-term performance figures of the exact same assets they choose riskier portfolios. This is mainly due to the fact that over shorter periods bond can outperform equities, however over longer periods, equities tend to outperform bonds. These are classic examples of framing - the time period in which you frame the returns and loss-aversion where losses hurt more than the joy of gains.
A recent example of a particular South African general equity fund, the PSG Equity Fund, made me think of this. First, let’s rewind back to 31 December 2015. The fund delivered a negative return (of -6.4%) for the year. What’s worse, from its high in April 2015 the fund suffered a drawdown of -15.5% to 31 December 2015. Over these same periods the JSE delivered 5.1% for the year and suffered a drawdown of only -5.1 between April and December of that year. Clearly the fund’s performance was poor, and most investors would find this difficult to stomach.
The pain, however, was not over and the fund continued to deliver negative monthly returns until it finally stopped in January 2016. How did investors respond to this? Well, they started selling out of the fund.
This was particularly regrettable as it was one of the best performing general equity funds during 2016, delivering 25.1% for the year. Furthermore the performance was achieved with an average exposure of resources over the period of only 11% and an offshore exposure of 23%, close to its maximum allowable 25% exposure. This is particularly impressive when one considers the strong performances of resources over this period and the adverse effect a strengthening local currency had on offshore investments. Over this same period the JSE All Share Index (J203T) delivered only 2.1%.
If we further compare the returns over the last two years we see some significant differences in performance. Since 31 December 2014 the PSG Equity Fund delivered 17.1%, (an annualised return of 8.2%), while the JSE delivered 4.1%, (an annualised return of only 2%). The PSG Equity Fund therefore outperformed the JSE by 6.2% per year over the last two years. Granted, this is over a very short term, but it does put the fund’s negative returns and drawdowns of 2015 somewhat in perspective. If investors got spooked by the poor performances of 2015 they would have missed some very good subsequent returns during 2016.
Looking at the fund’s 10-year history, ending 31 December 2016, the PSG Equity Fund exhibited an annualised tracking error (volatility of realised relative returns) over this period of around 8.53%. This roughly means that over a one-year period there is a 33% (one in three) chance of this fund delivering +/- 8.53% relative return versus the JSE All Share Index. What does this mean? If you want performance that is different to the benchmark you will get performance that is different to the benchmark! From a behavioural perspective investors need to make sure they understand this and that they are indeed able to stomach times of relative underperformance.
The graph below tells a familiar story of investor behaviour. Investors tend to sell out of, and buy into, funds at the wrong time. This largely explains why investors’ actual performance experiences are almost always different to the published fund returns, a phenomenon purely driven by poor investor decision making.
Equity as an asset class is risky - this we all know and accept - and therefore returns normally only materialise over longer as opposed to shorter time horizons. If we accept this, why are we not willing to stomach short-term volatility?
Let’s get back to myopic loss-aversion. As humans we suffer from a number of biases and we should accept that. Once we accept this, we will be better at trying to identify our own emotional or cognitive biases and respond accordingly. Clearly losses are painful, more so than the joy we experience when it comes to gains. However, we need to pay more attention to how we frame losses and realise that risk and reward go hand in hand. Portfolio managers need to be given the space to take appropriate “risk” so that longer-term capital growth may be realised.
Investors need to make sure that their willingness and ability to take risk are adequately reflected in their underlying investments. It is therefore crucial to obtain the professional advice of your financial advisor when trying to estimate your risk profile and subsequently choosing your investments. If your willingness and ability to take on risk has remained the same, you really should stay invested for the long term, despite short-term volatility or poor performances.
Naturally this is only true if you have done proper research into the managers you have selected to manage your hard-earned money. If you have been chasing performance you will run into difficulties in the future. A valid reason for selling out of a fund is if your investment thesis for choosing a particular manager has changed or if qualitative concerns exist regarding the sustainability of the fund manager’s business, the team, investment philosophy or the investment process. At Glacier Research we spend a lot of time focussing on these qualitative aspects, and are able to assist in selecting the appropriate managers.
With regards to the PSG Equity Fund, we maintain our positive view on the house, the team, their philosophy and process. The fund is part of our Shopping List, our best view range of funds, and has delivered consistent, superior relative returns over longer, more meaningful periods, to the benefit of our clients.
In conclusion, the next time your more risky investments do underperform, ask yourself what has changed. Are there material qualitative concerns when it comes to the managers you have selected or is the underperformance a natural part of the risk / reward spectrum? Your financial adviser, together with teams such as Glacier Research, can make a significant contribution in helping you answer these tough questions.