If you are invested in one of the many local unit trusts that have exposure to the equity markets, chances are you have received a statement recently showing that your investment has produced negative returns over the last year.
In this circumstance, it is tempting to label the asset manager responsible for your investment, incompetent. However, there are a number of factors that you need to consider, besides the nominal return, when evaluating their performance.
Firstly, the performance of your fund cannot be measured in isolation. Every unit trust fund is managed according to a specific mandate – which is simply a set of rules that determines amongst other things, what the objective of the fund is, what the fund manager may invest in and what the fund’s benchmark is. The benchmark tells you what performance the fund manager measures himself against. There is no use getting angry at a fund manager if he underperforms the equity market when his benchmark is cash, as most of your money would be invested in cash. In other words, the old saying of comparing apples with apples applies here.
In fact, a fund’s benchmark is one of the first things to look for before investing in a fund. Not only does it tell you how you should measure the fund manager, but it also gives a good indication of what your future returns will be.
Fund managers generally aim to give investors returns at least equal to that of the benchmark. To do this they will invest the majority of your money into the assets that generate the same return as the benchmark. Outperformance (a return better than the benchmark) is achieved by taking bets away from the benchmark. For example, an equity manager may endeavour to beat his benchmark by holding more shares of a company in his portfolio than is held in the benchmark.
Another important aspect to consider when evaluating the performance of your unit trust is the time period over which you are analysing.
Many investors are unhappy with the performance of their balanced funds because they have underperformed money markets over the last year. Over the last year the Alexander Forbes Money Market Index (AFMMI) has returned 10,78% versus the average Balanced Fund, which has returned -2%.
Many investors cannot understand how this is possible. The fund manager, on the other hand, knows that if equity markets decline, this affects the fund’s performance, because he has allocated a significant portion of the fund’s portfolio to equities. He understands that in order to outperform inflation over a 5 year period, he needs to hold more equities than cash as equities have the highest probability of generating returns above inflation over the longer term. He also knows that by selling the equities in the portfolio when they are not performing well, he will realise a loss. A fund manager using a benchmark with a rolling period, forces himself to stay the course and produce higher returns.
Indeed, the return of the AFMMI over the last 5 years is 55,81% compared to the return of the average balanced fund of 97,28%. That is almost double!
There are a variety of benchmarks used in the local asset management space, all of which can broadly be classified into the following categories:
- Index-linked benchmarks
Funds with index-linked benchmarks measure their performance against a certain index. An index is a portfolio of securities representing a particular market or a portion of it. The FTSE/JSE All Share Index, the All Bond Total Return Index and MSCI World Index are good examples of commonly used indices in South Africa. Index-linked benchmarks are mostly used for funds that only buy one type of asset class, e.g. equities, so it is easy to see what the index-linked fund invests in.
- Composite benchmarks
As the name suggests, composite benchmarks are created by combining at least two indices with different weightings to form a new composite index. This type of benchmark allows fund managers to invest in more than one asset class. For example, a balanced fund manager may invest in equities, cash, bonds, property and foreign assets. The composite benchmark gives investors a good idea of how the portfolio will be structured as fund managers normally align the asset allocation with that of the benchmark.
- Inflation-linked benchmarks
A common mistake many investors make is measuring their returns in nominal, as opposed to real, terms. Real returns are returns above that of inflation, i.e. nominal + inflation = real returns. While some older investors long for the mid 1980s when they could get 18% in a money market fund, they have forgotten that inflation was also as high as 20% during the same period! In fact, money markets outperformed inflation by only 1% on average during the 80s.
Funds with inflation-linked benchmarks aim to generate returns in excess of inflation, thus growing investors’ wealth in real terms. These funds normally utilise all the asset classes at their disposal. Investors therefore need to remember the golden rule of investing when buying inflation-linked funds: the higher the return, the higher the risk, or rather, the higher above inflation the benchmark, the higher the risk of the fund.
- Peer group benchmarks
Currently there are more than 700 unit trust funds in South Africa. All of these funds are categorised by ASISA according to their mandates and investment objectives. This makes it easier for investors to identify funds in a specific asset class or sector. For instance, all the property funds in South Africa fall into the Domestic Real Estate Index. Many investors who find the task of selecting a fund from a list of funds available in a category daunting make use of funds with peer group benchmarks. These funds aim to outperform the average of the funds in this sector.
So, when deciding whether your unit trust company is worth the fees they are charging you, remember to take benchmarks and time into consideration before making that call.