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Investors Guiding Stars - Eureka Report Article

June 7, 2006
Investors' Guiding Stars
By Scott Francis

PORTFOLIO POINT: Investors should look beyond just past performance, and beyond any financial planner that uses such ratings as their only criterion.

The managed fund industry in Australia is huge.  It is the world's fourth-largest after the US, France and Luxembourg and ahead of Germany, the UK and Japan, according to statistics published by the US Investment Company Institute. At the end of 2005, Australian managed funds held more than $700 billion or, based on a population of 20 million people, $35,000 for every man, woman and child in Australia.

The Morningstar website says it provides research on more than 7500 Australian managed funds. To put this in perspective, at December 31, 2005, there were 1873 listed companies on the Australian stockmarket. Not all the managed funds will be invested in Australian stocks, but the fact there are four times as many managed funds in Australia as there are listed companies on the ASX is testament to the size of the industry in Australia.

Why is this the case? First, Australia's superannuation industry sees 9% of most people's salary invested in managed funds, providing an ongoing stream of contributions to managed funds. Second, Australia's financial planning industry is dominated by advisers who generate their cash flow from the commissions paid by managed funds to them.

A reasonable question to ask is how investors and advisers assess the myriad managed funds available to them, and how successful this process is.

It is worth starting with a paper written by Julia Sawicki, a financial academic and Kevin Thomson, a financial planner, which examined two key inputs into the process of selection managed funds, research company ratings and the past performance of managed funds. Their paper, An Investigation into the Performance of Recommended Funds: Do Managed Funds 'Approved' by Research Companies Outperform the Non Gratea?' (not approved), studied two key approaches to choosing funds, the use of research companies to rate managed funds and the use of past performance to predict a fund that would outperform.

Sawicki and Thomson had access to the ratings from a research company for the six years from 1989 to 1995. They found no evidence that "approved" funds outperformed those that were non-approved. In fact, they set up two hypothetical portfolios in which $1000 was invested into each of the 14 category of funds (capital stable, equity and international funds) and received the average return for either the approved funds or the average return from the non-approved funds. At the end of the six years the approved fund portfolio was valued at $21,027 and the non-approved fund category was $21,540.

Their conclusion was clear: "The results generally reveal no significant difference between the performance of approved and non-approved funds on a group as well as an individual basis, suggesting that the classic return-maximising investor would not be aided by the research companies' recommendations."

The period that was studied was some time ago, 1989 to 1995, so it is worth looking at the present ratings system to see what value it may add to an investor. Possibly the best-known ratings company is Morningstar, which rates managed funds on a scale from one to five stars. An article by Phillip Gray found on the Morningstar website provides some information on the methodology behind the star rating system. Funds are rated using a combination of three and five-year returns data, with the results adjusted for the volatility of returns. A fund with a similar level of returns to another, but with greater volatility of returns, will receive a lower rating. Volatility is measured on the basis of monthly returns.

Funds are then allocated a star rating based on their historical return, adjusted for volatility. A five-star fund is in the best 10% of funds of that type, a four-star fund the best 22.5%, three stars the middle 35%, two stars the next 22.5% and a one star fund the worst 10%.

This process of rating funds from one to five stars is a completely quantitative process, and does not capture the value that may be added by the qualitative process that a researcher such as Morningstar will do. That said, the five-star system is a powerful and simple way of branding managed funds for investors. Clearly, this system is based heavily on historical returns, which was investigated in the second part Sawicki and Thomson's study.

In looking at the ability of historical managed fund returns to predict future returns, Sawicki and Thomson found no evidence of "persistence" of returns; that is, there was no evidence that choosing a managed fund that had outperformed in the past would provide above-average returns in the future.

This conclusion is one that has been reached by many researchers. Mark Carhart, in his paper On Persistence in Mutual Fund Performance published in the Journal of Finance in 1997, found there was no evidence of persistence in the performance of managed funds. Academics Michael Drew and Jon Stanford of the University of Queensland, wrote the paper Returns from Investing in Australian Equity Superannuation Funds, 1991-1999 that was published in the Services Industry Journal in 2003. They found "no evidence that active fund management adds value" and "the market for equities in Australia appears to be remarkably efficient".

These conclusions contradict the idea that a fund manager can consistently outperform the market. In fact, Drew and Stanford found that on average fund managers underperformed passive index returns by 2.80% to 4.00%. The conclusions reached by Carhart, Sawicki and Thomson, Drew and Stanford are important as they questions any link between historical returns and future returns, which is a key element in the rating of managed funds.

If all the research is put together a reasonable conclusion is:
  • Sawicki and Thomson found that no value is added by the quantitative process of rating managed funds by looking at the actual data from an ratings agency.
  • Past performance is not a good indicator of future performance; that is, there appears to be little evidence of persistence in returns.
  • Given that past performance is a critical input into the process of rating managed funds, the process is likely to add little value for investors

On a practical level, this means a financial planner is likely to be adding little to your financial situation if they rely on a managed fund selection process that involves using ratings from a research company and the past performance of a fund manager.

If it were as simple as identifying a fund that had outperformed in the past, we could all choose our own investments with confidence. Moreover, the results that showed managed funds underperforming passive index benchmarks by 2.8% to 4% must bring into questions whether managed funds are the ideal vehicle to use for managing your wealth, and whether they deserve such an important place in the Australian investment industry.

* Scott Francis is an independent financial planner based in Brisbane. He has an MBA from the University of Queensland.