Active management performance

meester

Interesting study:

http://pensions-institute.org/workingpapers/wp9903.pdf

We find that the average UK equity fund appears to underperform by around 1.8 percent per annum on a risk-adjusted basis

BUT

There is also some evidence of persistence of performance: on average, a portfolio composed of the historically best-performing quartile of mutual funds performs better in the subsequent period than a portfolio composed of the historically worst-performing quartile of funds

Exclusion of dead funds from studies of returns on mutual funds can induce a potentially serious survivor bias in the reported performance measures

Following the analysis of Hendricks et al. (1993) we sorted, for each month, funds into quartiles based on their abnormal performance over the previous 24 months. Only funds with a complete record of returns over this period were considered. Then equal-weighted portfolios comprising the best (top quartile) performers and worst (bottom quartile) performers were formed and held for one month.

All of the UK equity portfolios derived from the best performers produced positive mean abnormal returns over the sample period, while, conversely, all of the portfolios consisting of the worst performers produced negative mean abnormal returns. Of particular note is the large difference between the best and worst performers in the UK smaller companies sector. These findings suggest that there is considerable persistence in abnormal returns and that past abnormal returns do provide important information useful for selecting future portfolios

We also have important new results for asset categories apart from domestic equities. Compared with the domestic equity sectors, the survivor bias seems to be much larger in sectors such as North America, Europe, Australasia and international equity income.

Shukla and VanInwegen’s study of UK growth-oriented mutual funds investing in the US found that they underperformed their US counterparts. The UK funds were smaller than the US funds and so had more limited resources for research. They relied more heavily on US brokers’ recommendations (which might be tainted by their own company’s inventory levels in particular stocks or underwriting offerings) and made far fewer personal company visits prior to investing. UK fund managers tended to have less well-established business relationships with investment bankers and so received less favourable treatment in new issues, for example, compared with their US counterparts. They were alsodisadvantaged in terms of trade execution as a result of noncoincident business days (e.g. the heaviest trading in US stocks and hence the most significant price discovery tends to occur in the last half-hour before the US market closes). Further, the investment styles of the two groups of fund managers differed, with UK fund managers favouring asset allocation and market timing strategies, whereas their US counterparts favoured quantitative (bottom up) stock selection

meester

Here's another one:

http://repec.org/mmfc04/55.pdf

UK Mutual Fund Performance: Genuine Stock-Picking Ability or Luck

"This study finds strong evidence in support of genuine stock picking ability on the part of many top ranked UK equity unit trusts.

The existence of stock picking talent is more strongly supported among income funds and among growth funds but is less evident among general equity funds and among small stock funds."

meester

http://www.dfaus.com/library/reprints/uk_equity_trusts/

Performance of UK Equity Unit Trusts

This examination of UK equity unit trusts says that UK money managers are unable to outperformed markets in any meaningful sense, that is, once we take into account their exposure to market, value and size risk. This result is analogous to most studies of US money managers. Even more dramatic than these overall results are the findings for the small-company UTs. Contrary to the notion that small-company shares offer abundant 'beat-the-market' opportunities, we find that small-company UTs are the worst performers. In fact, their performance failure is persistent and reliable.

Does performance persist? Yes, but only poor performance. As others find for US mutual funds, so we find in the UK. Losers repeat, winners do not. Only after adding back estimated expenses can we find evidence that the most successful UTs repeat their winning performance. (Ironically, so do the losers.) The winners' repeat performance, gross of expenses, is intriguing but not exploitable because of high turnover costs.

meester

http://www.fsa.gov.uk/pubs/occpapers/OP09.pdf

A number of researchers have examined whether past investment performance repeats. The conclusion from an examination this literature is that repeat performance (if there is any) is both small in the size of effect and short lived. Repeat performance (persistency) is most evident for smaller poorly performing funds but the degree of persistency remains low. The conclusion from studies of UK unit trusts, and the more reliable of US studies, is that retail investors could not usefully exploit information on past performance.

A simple analysis of whether relative performance persists was undertaken by WM Company (1999), in comparing active and passive fund management. They examined funds in the top 25% of performers over five year periods in the UK Growth and Income Sector for a period of 20 years (1979 to 1998).

WM found that funds which are initially ranked in quartile 1 show no more than a random chance of being similarly ranked in a subsequent period

2. In fact they found that a fund ranked in quartile 4 showed a stronger probability of subsequently being ranked top. The conclusion was that historic top quartile performance was not a good guide to picking funds.


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Refuting the above:
Performance persistence in UK equity funds – An empirical analysis
http://www.investmentuk.org/press/2002/20021014-01.pdf

Choosing a top quartile fund, as opposed to a bottom quartile fund will, on
Choosing a top quartile fund, as opposed to a bottom quartile fund will, on average, add to an investor’s potential return. The cumulative return for funds that are in the top quartile exceeds the returns of those in the bottom quartile over the majority of time horizon and sector combinations;
We conclude that, based on our dataset, consumers (and their advisers) can use past performance information as a beneficial part of their investment decision-making process

The statistical tests suggest that much of the observed persistence is strongly significant, much at a confidence level as high as 99.9%. From this there appears to be very little doubt that investors can derive useful evidence from past performance data. The results are stronger both in the UK All Companies and UK Equity Income sectors – where there is significant evidence of persistence over a number of time periods. The UK Equity and Bond and Smaller Companies sectors show weaker results, although persistence is still strong over relatively short periods. The strength of persistence in the short term is a result echoed by other studies. We have only tested one potential model – investment based on selection from the top quartile. It should be noted that other strategies could be even more powerful than this

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Refuting that:

http://www.fsa.gov.uk/pubs/other/pastperf_mutalfunds.pdf


We do not believe that CRA’s decision to conduct their analysis of performancepersistence using raw returns is justified. The absence of risk adjustment in theperformance study means that performance persistence figures are likely to divide mutualfunds according to their levels of risk exposure and not according to the degree of fundmanager skill or value-added. High-risk funds are more likely to be top performers(particularly in the long run), while low-risk funds are more likely to be among the worstperformers. Performance figures based on raw returns are likely to induce investors tohold more mutual funds with high risk and fewer mutual funds with low risk, regardlessof whether the returns generated by these funds are justified by their level of risk.

We do not think that the publication of persistence measures that induce investors to seekmore risk are in the best interests of investors. No skill on the part of a fund manager isrequired to select a high-risk strategy. To the extent that superior performance in rawreturns merely reflects higher levels of risk, it can be replicated at a lower cost (sinceactive fund management fees can be avoided) by using a geared or leveraged investmentstrategy based on tracker funds. If the purpose of performance league tables is to enableinvestors to select the most skilfully run mutual funds, performance should therefore bemeasured and reported on a risk-adjusted basis.

If mutual funds are left to advertise past performance figures on their own and are free tochoose the way in which they do so, this is unlikely to bring as much attention to pastunderperformance as would seem appropriate given its persistence. Superior performance,though less persistent, is likely to be more aggressively promoted through voluntaryadvertisement than underperformance. Hence, we believe it is important for both existingand potential investors in mutual funds to have an independent outlet that reportspersistent underperformance on a risk-adjusted basis where this exists.

We therefore believe that there is a reasonable case for arguing that risk-adjusted past-performance data should be included in the FSA’s Comparative Tables. This is notbecause of the traditional argument over whether superior performance might or mightnot persist, which we regard as inconclusive, but rather because of the evidence thatinferior performance seems to persist. We believe it is important for investors to haveeasy access to reliable information on underperforming funds so they can modify theirinvestment strategies accordingly. Additional research needs to be undertaken on the mostsuitable risk-adjustment procedure as well as the most suitable investment horizon overwhich past performance is reported

An unskilled fund manager can increase the fund’s average raw return over time simplyby increasing its risk exposure. The simplest way to do this is through gearing orleverage, that is, borrowing money to invest in additional risky assets. However, thiscomes at the expense of increasing the fund’s risk as measured by its beta. Only skilledfund managers can improve on the fund’s ratio of expected excess return to market (i.e.,beta) risk (known as the Treynor (1965) ratio)
Alpha is a measure of risk-adjusted performance since it controls for the fund’sexposure to risk. Hence, if a particular mutual fund earns a high average return notbecause the manager is skilled but simply because the manager took on a high level ofrisk (i.e., chose a portfolio of assets with high betas), this will not show up in Jensen’salpha. In contrast, if raw returns are used as a performance measure, even a poor fundmanager with a negative value-added (a< 0) could appear to outperform by choosinga high-risk (high ß) strategy. This is because on average, over long periods of time, themean excess return on the market portfolio, i.e., the market risk premium (Rmt- Rft),tends to be positive. If a mutual fund holding represents a small part of an investor’s total portfolio, then alpha is an appropriate measure of the mutual fund’s performance, since thecontribution to overall portfolio risk depends on how much market risk the mutual fundtakes on. It is thus necessary to control for market risk exposure. Performance measures such as the Sharpe (1966) ratio(the ratio of the mean excess return to the standard deviation of portfolio returns) can beused in this situation.

The most important investment decision an investor makes is likely to be his or heroverall strategic asset allocation (SAA), i.e., how much of total wealth to invest inbroadly defined asset classes, such as UK and international stocks, bonds, property andcash. The SAA should be based on a careful consideration of both available investmentopportunities and key characteristics defining the current stage in the investor’s lifecycle (such as existing and future family commitments, the anticipated length of theremaining working life, and projected earnings over this period). The SAA alsodepends on the level of risk that is acceptable to the investor. The selection of specificmutual funds should therefore be seen in the context of and in relation to the SAA.1.19.One way to conceptualise the investment process is to assume that investors have a riskbudget that allows them to accept a certain level of total risk across all their investmentholdings. If they spend this risk budget on high-risk, actively-managed mutual fundsthat do not add any value on a risk-adjusted basis, then they are unlikely to outperforma simple passive strategy invested in tracker funds with the same overall level of risk.Of course, in practice investors will trade off risk against expected returns in theirportfolio decisions

As we have stated above, many studies in the empirical literature on mutual fundperformance find that underperformance persists. A potentially significant benefit fromreporting persistence is that funds, if required to disclose their performance over a fixedrecent period, would be given a stronger incentive not to underperform.
Currently, there is an important asymmetry in how funds promote their performancefigures. The advertisement of funds’ past performance is voluntary although it isregulated and a certain amount of standardised information must be reported infootnotes. In practice, this means that superior past-performance records are activelypromoted, while poorly performing funds are far less likely to advertise their pastperformance. This gives an incentive for mutual fund houses to engage in risk takingacross the individual funds in their stable (known as families in the literature). Superiorperformers (the lucky ones.) can be heavily advertised, while inferior performers (theunlucky ones.) do not have to be actively publicised.

A key finding of CRA’s empirical analysis of the performance persistence of UKmutual funds is that: ‘the importance of persistence depends on both the time horizonand the sector in which the fund is invested: performance is strongly significant only inthe short-term for funds in the Equity & Bond Income and Smaller Companies sectors;however, it is significant over all time horizons for the UK All Companies and UKEquity Income sectors’ (CRA2, p.1).
We have argued in our report that this result could well be explained by differences inrisk in the short term and by the risk premium in the long term and need not reflect anyintrinsic superior investment skills by the fund managers involved.
Further, the investment strategy which follows from this and which CRA recommendscan be summarised succinctly as: ‘invest in high risk funds and hope for the best, sinceif you hold the investment for long enough it generally works out’. This strategy,because it in effect discounts any notion of fund manager skill, has a number ofimplications:
•Investors do not need to pay for active fund management, since they can replicatethe high-risk exposures of active fund managers more cheaply using a combinationof home-made leverage and tracking funds.
•There is no need for the sector allocation of unit trusts. If the objective is to havehigh returns, why divide unit trusts into sectors. Why not group all the fundstogether and select those from the highest quartile of past performance

If [fund managers] wish to improve value added in the [fund management] industry,they should compete on the basis of their charges, rather than on the basis of theirpast performance or their promised future performance’

jamesd

Thanks for posting those. Interesting indeed, here's a quick summary of very preliminary thoughts of the first few:

Pensions Institute study, says it's studying fund managers, actually studied fund management companies and ignored managers. Interesting observation of better initial performance and worse ending performance, but no attempt seems to be made to analyse why these things happened (those interested in managers would hypothesise that for over-performers that become underperformers a manager change is the key factor). Study data ended in 1995.

UK Mutual Fund Performance: Genuine Stock-Picking Ability or Luck, studied funds not managers. Ended in December 2002 which may explain why small companies funds did worse than in the Pensions Institute study.

Performance of UK Equity Unit Trusts, Journal of Asset Management study, data ending 1997. Studied funds rather than managers. "The winners' repeat performance, gross of expenses, is intriguing but not exploitable because of high turnover costs". Those costs were from chunks of funds in each ten percent of returns, selling and buying each year so that you held the ones that were in the top 10% each year based on one year's past performance. This led to 83% fund churn at the top 10%, more in the middle. The cost of buying was 5% bid-offer spread and I think 0.5% stamp duty. That was enough to exceed the 0.9% performance difference between best 10% and middle pair of groups. The performance difference between the top 10% and second 10% was 0.53%, not enough to make it worth changing from a move into that second group. Not sticking rigidly to the 10% chunks they used and not holding all of the top 10% to magnify the churn effect might be interesting, particularly with the lower costs of buying from discount brokers. Would be interesting to know how much funds moved out of their previous band.

meester

jamesd wrote: »

Thanks for posting those. Interesting indeed, here's a quick summary of very preliminary thoughts of the first few:

Pensions Institute study, says it's studying fund managers, actually studied fund management companies and ignored managers. Interesting observation of better initial performance and worse ending performance, but no attempt seems to be made to analyse why these things happened (those interested in managers would hypothesise that for over-performers that become underperformers a manager change is the key factor). Study data ended in 1995.

UK Mutual Fund Performance: Genuine Stock-Picking Ability or Luck, studied funds not managers. Ended in December 2002 which may explain why small companies funds did worse than in the Pensions Institute study.

Performance of UK Equity Unit Trusts, Journal of Asset Management study, data ending 1997. Studied funds rather than managers. "The winners' repeat performance, gross of expenses, is intriguing but not exploitable because of high turnover costs". Those costs were from chunks of funds in each ten percent of returns, selling and buying each year so that you held the ones that were in the top 10% each year based on one year's past performance. This led to 83% fund churn at the top 10%, more in the middle. The cost of buying was 5% bid-offer spread and I think 0.5% stamp duty. That was enough to exceed the 0.9% performance difference between best 10% and middle pair of groups. The performance difference between the top 10% and second 10% was 0.53%, not enough to make it worth changing from a move into that second group. Not sticking rigidly to the 10% chunks they used and not holding all of the top 10% to magnify the churn effect might be interesting, particularly with the lower costs of buying from discount brokers. Would be interesting to know how much funds moved out of their previous band.

On the small companies funds I'm not sure what difference 2002 makes - they are saying that the small companies managers do not perform as well as the small companies sector (the passive index in effect) - not that small companies do not perform per se. Whether or not a market is rising or falling, a skilled manager should by definition deliver better performance (bigger rises or smaller losses). If the small companies sector was not performing then, it suggests that any outperformance in rising times is simply due to the effect discussed in the last study, namely that supposed outperformance is actually a function of managers increasing risk.

On the latter point of churn costs, agreed that the costs seem OTT. With an OEIC, the cost to switch should be nil. An annual rebalancing strategy on that basis would certainly be interesting - every 12 months.

meester

meester wrote: »

On the latter point of churn costs, agreed that the costs seem OTT. With an OEIC, the cost to switch should be nil. An annual rebalancing strategy on that basis would certainly be interesting - every 12 months.

And actually most UTs do not charge that much either. Once you take off the initial charge, the bid/offer spread is usually well under 1%, even with illiquid funds the managers usually offer a better bid/offer price than the underlying cost of purchase/cancellation.

jamesd

Well, rebalancing between sectors every 12 months maybe. But if a human manager or team changes it's fairly widely thought that selling or holding beats taking a risk on the new manager, so switching to a different fund of the same type with a manager who's a known quantity may well reduce the downside risk. Essentially a "you're guilty of poor performance" assumption immediately instead of waiting until the end of the year. And this sort of guidance is routinely provided by even discount brokers like Hargreaves Lansdown. Can only wonder what difference this makes to overall performance but in the (small sample) global growth look I took there were some pretty dramatic falls after manager changes, far more than seemed typical without such a change.

Given sector-based portfolios with rebalancing between sectors I doubt that you'd be buying as often as they did because I assume that ranks within sectors will be more stable than ranks across sectors, as apparently used in the performance consistency check.

But I still haven't done any more reading of those and won't get much chance until Sunday at the earliest.

meester

jamesd wrote: »

Well, rebalancing between sectors every 12 months maybe. But if a human manager or team changes it's fairly widely thought that selling or holding beats taking a risk on the new manager, so switching to a different fund of the same type with a manager who's a known quantity may well reduce the downside risk. Essentially a "you're guilty of poor performance" assumption immediately instead of waiting until the end of the year. And this sort of guidance is routinely provided by even discount brokers like Hargreaves Lansdown. Can only wonder what difference this makes to overall performance but in the (small sample) global growth look I took there were some pretty dramatic falls after manager changes, far more than seemed typical without such a change.

Given sector-based portfolios with rebalancing between sectors I doubt that you'd be buying as often as they did because I assume that ranks within sectors will be more stable than ranks across sectors, as apparently used in the performance consistency check.

But I still haven't done any more reading of those and won't get much chance until Sunday at the earliest.

There's quite an interesting thread at TMF on mechanical momentum-based fund buying here:

http://boards.fool.co.uk/Message.asp?mid=10617466&sort=whole

Based on six-monthly trailing performance two or three funds are purchased as the top funds overall, but subject to being in different sectors. The observation appears to be that high-performing funds tend to do well for a couple of years so there is still momentum even if you have missed the initial performance boat.

There seems to be something of an imperative to switch funds quickly - something like Legg-Mason Japan rose 61%, 40% and then 25% annually, followed by 39% and 42% annual falls.

MoneyTown

meester wrote: »

There's quite an interesting thread at TMF on mechanical momentum-based fund buying here:

http://boards.fool.co.uk/Message.asp?mid=10617466&sort=whole

.

Yeah I like this idea though he appears to throw all his money behind the best fund and ignores sector allocation !! He says further down:

"I used to select 2 or 3 funds to provide diversification. For example, if the top say 5 funds were all Japanese then I would only pick one of these and move down the list for alternatives. However, I have since given up on this, and now I just invest everything in the 1st placed fund (currently Gartmore China). Whilst this may be more risky, I am happy with the trade-off. I am also a big fan of keeping things as simple as possible (hence also the reason for only using the 6mRS ranking)."


It has its merits though and I reckon using the Trustnet 6 month ratings:

http://www.trustnet.com/ut/funds/perf.aspx?txtSearch=&btnSubmit=Search...&universe=ut&btnGo=%3CSPAN+class%3DbuttonLeft%3E%3CSPAN+class%3DbuttonRight%3EGo%3C%2FSPAN%3E%3C%2FSPAN%3E&nsUniverse=UT&sort=28&ss=0&txts=&txtss=&columns=13%2C28&page=0&booIMA=0&reg1=jap&sec=all&ima=all&unit=all&type=all

and balancing fund purchases across sectors and then rebalancing every 6 months could be worth a try!