In tough times, true skill materialises

It certainly has been a good time to be invested. Over the past four years, the average general equity unit trust fund has produced a return in the region of 40% per annum (compared to the long-run equity return of 13% per annum since 1900). It is interesting that the difference in performance between the funds in the general equity universe is currently low relative to history. In other words, the performance divergence between the top funds and bottom funds has been much lower than usual.

This is presented in the chart and table below, which highlights the performance of all General Equity Unit Trust funds for each of the one year periods starting in March 1999 and ending in March 2007.

Source: Morningstar

For any one-year period ending in March, the red block in the graph above represents the range of performances for second and third quartile funds (i.e. the middle 50% of funds in terms of performance). The blue lines extending from each red block represent the range of performances for the first and fourth quartile of funds (the top 25% and the bottom 25% of performers).

As an example, in the year ending March 2007:

- the median fund produced a return of 32%,

- the middle 50% of funds (those that fall into quartile 2 and 3) produced returns ranging from 30% to 35% (a range of 5%), and

- the best performing fund produced a return of 45% and worst performing fund a return of 19% (a range of 26%).

It is clear from the above that the difference in returns between the top and bottom performing funds has been on the low side, ranging between 19% and 26% over the past four years (less than half that of the previous four years, which ranged between 41% and 69%). The same applies to the funds in the second and third quartile: over the past four years the range between these has only been between 5% and 7%, compared to 10% and 15% in the previous four-year period.

For investors, this has meant that exposure to almost any general equity unit trust fund over the past four years has delivered very satisfactory absolute returns, and little chance of a big disappointment in relative terms. That is a very different picture than for those invested in the more volatile times of 2000-2003, when the difference between being invested in the best fund or worst fund could have meant a return of +24% versus -30% in 2001 alone!

So what does all this mean? Well, it seems that there have been few opportunities over the past four years for skilled managers to show their mettle. A truly skilled fund manager is one that can do well through the complete market cycle (a bear and a bull market). Investors may not realise just how important it is to invest with those managers who have the ability to add value when the market becomes more volatile or enters another bear market.

To understand this better, we have further explored how those managers with exceptional long-term track records (over bull and bear markets) have achieved them. We scoured the landscape for long-term track records of equity fund managers that have provided investors with returns well in excess of benchmark returns. We tested whether or not those managers added more value to the benchmark when markets were producing above-average returns (lets call these bull markets), or below average returns (bear markets). Our results are presented in the table below.

Source: Nedgroup Investments

We studied only those local equity managers that had twelve or more years of performance history and had added more than 7% per year, on average, to the benchmark over that period. In terms of international managers, where we could work with longer track records, we identified managers with 17 or more years of performance history, who added more than 3.5% to the benchmark per year over that period.

Although our list is not exhaustive, it does lead to some interesting conclusions:

- Firstly, the best managers achieved the bulk of their outperformance in years when the market was producing below average returns.

- For South African fund managers:

* 64% of the total outperformance was achieved when markets produced below-average returns

* all managers in the sample delivered more than 50% of their outperformance in below average market conditions

* the managers produced returns of 13% per year versus the markets 0% per year in below average years

-  For international managers:

* 78% of the total outperformance was achieved when markets produced below-average returns. In other words, nearly four times more alpha was produced in below average market conditions than in above-average market conditions

* all managers in the sample delivered more than 50% of their outperformance in below average market conditions

* the managers produced marginally positive returns (+2%) versus the markets -9% per year in below average years

The very best managers have differentiated themselves in times of market weakness and volatility. Therefore, look to managers with a proven ability in bear markets, as it is these managers that become the stars over the long term. This advice may be particularly important now, given that the returns generated by the market over the past four years far exceed the long-run average, and more normalised returns can be expected going forward.