Three investment articles have caught our attention recently. The first, “Shopping for Alpha: You get what you don’t pay for” (May 2011) is a detailed research document looking at ways of identifying superior funds. The second is “Keeping the cost monsters at bay” by Patrick Collinson in Fund Strategy (7th November 2011) and the third, “Last refuge of overblown management fees” by David Stevenson in the Financial Times (12th November 2011). In this article we will look at some of the conclusions from these pieces.

Starting with the Vanguard research, the aim of their paper was to explore the relationship between past performance and future performance and then look at alternative attributes of successful funds.

Their first conclusion and one that is well known is that past performance is no guarantee of future performance. Vanguard looked at a Morningstar database of actively managed funds in the US for a twenty year period from 1990 to 2010. They then calculated alphas (alpha being a portfolio’s risk-adjusted excess return versus its effective benchmark) relative to the stockmarket’s four common risk factors, namely:

• Market risk
• Small cap risk
• Value risk
• Momentum risk

For each rolling 36 month period, they then grouped the funds in quartiles from lowest alpha to highest alpha. Once done, they calculated the probability that the same fund would remain a top quartile performer over the next 1, 3, 5 and 10 year time frames. The result was that the probability that the highest alpha funds will remain the highest alpha funds in subsequent periods was no better, and sometimes worse, than chance. A random distribution would give 25% in the top quartile.

Probability of remaining in top quartile

The results were markedly worse when survivorship bias (not all funds from 1990 remained open in 2010) was removed with only 9% expected to remain top quartile over 10 years.  Fund management groups are well known for closing their poor performing funds or merging them with better funds to improve their published performance.  When these funds are taken from the overall performance figures it makes active managers look significantly better than the true picture.

The next step of their research was to look at Morningstar Ratings. These range from 1 star (the worst risk-adjusted performance relative to peer group) up to 5 stars. Vanguard research (Philips and Kinniry 2010) looked at whether these ratings could help identify top performing funds over the next 36 months using data from June 1992 to August 2009. The result was that star ratings were no guide to future performance.  Indeed, 5 star funds were less likely to outperform their benchmark than 1 star funds!

Vanguard then looked at how other variables might impact on performance. Variables researched were:

• Fund expense ratios
• Portfolio turnover
• Fund asset size
• Fund age

The conclusion here was that, on average, for every 1% increase in expenses, alpha declined by 0.78% p.a. In other words, there was a significantly negative correlation between expenses and alpha.  This comes as no surprise at all to us.  If a fund manager spends an extra 1% in costs, an additional 1% return has to be delivered consistently just to break even.

Portfolio turnover rates produced a similar, but less pronounced, result with every 1% increase in portfolio turnover giving a 0.22% drop in alpha. In other words, trading within a portfolio was also destroying alpha. This is probably in part due to the costs associated with trading but also because short term stock selection is very difficult to get right.

The size of a fund and the age of the fund didn’t produce statistically significant results.

Vanguard’s conclusion was that active management is both art and science. Talent exists, and produces alpha, but its basis can’t be captured in a mechanical formula. In contrast, the expense ratio is a useful indicator of a fund’s relative performance.

This then brings us on to two points from the Fund Strategy article. Firstly, this quotes some Morningstar research which concludes:

“Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you'll be on the path to success.”

The second point it that whilst annual management charges (AMCs) might average around 1.5% p.a. and Total Expense Ratios (TERs) a further 0.2% p.a., trading costs are on top of this and add around 1.1% p.a. to the average UK equity fund.

Both of these findings seem to amply back up the Vanguard data.

As many Evolve clients will be aware, although the idea of investing in other asset classes sounds good, we stay clear of more esoteric asset classes.  Research suggests that although such asset classes may initially appear to offer diversification benefits, these benefits offer little or no protection on the downside.  The reasons for this are varied, but what is clear is that alternative asset classes are expensive to invest in.

This brings us on to David Stevenson’s article which concerned private equity funds. In this, private equity group Kohlberg Kravis Roberts stated that fees across all of its funds average 7% p.a. Research from Numis securities showed that just one listed private equity fund charged less than 2% p.a. and only 3 charged less than 3% p.a. Seven funds charged more than 5% p.a. on average.

The same is true of hedge funds.  If you want to get rich it is almost certainly better to own a hedge fund than invest in one with the traditional “two and twenty” (2% p.a. plus 20% performance fee) charging structure.  That's the conclusion of a new book, which says people who invest in hedge funds would have been better off over the past nine years if they had stuck to a broadly diversified portfolio of “plain vanilla” stocks and bonds.

The book is called 'The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to be True'. It was written by Simon Lack, an asset manager who formerly chose hedge funds for major US bank JPMorgan.

Lack argues that the 18% return on hedge funds in the nine years to November 2011 was easily beaten by the total 29% gain from the S&P-500 index. The gap was even starker for investment grade corporate bonds, which in the same period gained 77%, as measured by the Dow Jones Corporate bond index.

If individual hedge fund managers are generating the desired "alpha", or additional returns above the market, then the benefits of that skill tend to go to the managers themselves, not to investors.

In fact, Lack estimates that from 1998 to 2010, the hedge fund industry captured at least 86% of the returns it earned for its customers. This might explain why yachts cruising the Caribbean tend to be skippered by hedge fund managers, not investors!

Our message to clients has always been, and will always be, put together an asset allocation strategy that is right for you and then within each asset class or geographical region look for the lowest cost, best diversified fund that you can find. Investment should be boring and might only bear results over the long term – if you want excitement and a short term kick, go to Vegas!