It has been a volatile six months in the markets, following a five-year period of disappointing equity returns. At times like these, it is understandable for investors to question both their investments and their investment manager. Nomi Bodlani and Tamryn Lamb discuss key considerations when evaluating your investment manager.
Trust implies a hoped-for outcome. When an investor entrusts an active investment manager with their hard-earned money, they are essentially expressing their confidence in the manager’s ability to deliver performance relative to the objectives of their investment. Typically, these objectives will include both focusing on protecting capital and delivering returns in excess of those generated by a comparable investment alternative, i.e. the benchmark.
A common saying in the investment industry is that performance does not come in a straight line. Of course, while this may be true, it does not make it easier to bear those inevitable periods when performance disappoints – on an absolute basis or relative to other managers or benchmarks. How do you retain trust and confidence in your manager over the full life cycle of your investment?
To gain clarity, we would want our clients to consider the following two questions, which we also believe are broadly applicable to any investment manager you choose to place your trust in:
- What are you trusting your manager to do?
- How do you know if you can trust your manager to deliver on your expectations?
What are you trusting your manager to do?
Once you have established your personal goals and objectives, before committing to any new investment, you should ensure you are clear on what you expect from both your chosen manager and your fund. Your expectations of your fund should be directly informed by the stated objectives of the fund.
Every fund has a minimum disclosure document or fund factsheet. This document contains key information about the fund, including its mandate and objective. Typically, this objective will detail the fund’s benchmark, time horizon and risk positioning.
before committing to any new investment, you should ensure you are clear on what you expect from both your chosen manager and your fund
Let’s take a look at the Allan Gray Balanced Fund as an example:
The Fund aims to create long-term wealth for investors within the constraints governing retirement funds. It aims to outperform the average return of similar funds without assuming any more risk. The Fund’s benchmark is the market value-weighted average return of funds in the South African - Multi Asset - High Equity category (excluding Allan Gray funds).
The following information from the Balanced Fund’s objective will help you to identify what to expect:
- Fund return expectations
Actively managed funds aim to deliver better returns, net of relevant fees, than their selected benchmarks. The Balanced Fund aims to perform better than the average performance of similar funds in South Africa.
When a fund outperforms its benchmark, we call this positive difference in performance “alpha”. Over the last 20 years, the average fund in the Balanced Fund’s sector generated real returns of approximately 5%. The Balanced Fund generated real returns of just under 10%. Absolute and relative returns in the future may not be as good as in the past, but this is a useful starting reference point for your return expectations.
- Risk measures
Return expectations are closely linked to risk considerations. You will typically need to take on more risk in pursuit of higher returns. At Allan Gray, we think the most important measure of risk is the risk of permanent capital loss.
As a prospective investor, we therefore believe it is important to view the maximum drawdown (the maximum loss from peak to trough) a fund has experienced, or the lowest annual return. These measures should be considered alongside the time it has taken to recover. The lowest annual return of the Balanced Fund, for example, was -14% (for the 12 months ending March 2020), which compares to the market of -16% (for the 12 months ending February 2009). This drawdown has subsequently been recovered, such that the rolling one-year return at September 2020 is flat. Ideally, a fund should experience a lower average drawdown than the market and recover more quickly. The factsheet will also include measures like volatility, which is the monthly variance in return relative to the average.
- Time horizon
This is the minimum amount of time that an investor should remain invested in a fund, and should be seen as a reasonable period over which to assess whether the fund has delivered on its objective. The Balanced Fund aims to deliver returns in excess of its benchmark with lower risk of loss over periods of more than three years.
This doesn’t mean that the Balanced Fund will beat its benchmark over its time horizon every single month. Many successful funds will have periods when they underperform significantly. The key is to make your assessment over sufficiently long and representative periods.
If you consider that, over its 20-year history, despite its long-term outperformance, the Balanced Fund has beaten its benchmark (based on three-year rolling returns) only ~86% of the time, it is certain that there will be months when it doesn’t beat its benchmark over a three-year period. However, when you look at the Fund’s performance over a longer term, say five or 10 years, you start to see the consistency in delivering alpha. Since inception, the Balanced Fund beat its benchmark, on a five-year rolling return basis, in ~98% of months.
How do you know if you can trust your manager to deliver?
Let’s say your favourite sporting team won the title in 2019. No matter how much you wish and hope they replicate this result in 2020, you have no guarantee that they will. However, there are certain inputs they can replicate which they know have been successful in the past: selection, training, nutrition, and so on. So even though they can’t guarantee the result, they can be consistent in their previously successful inputs and trust that they will deliver the best possible outcome, as they have in the past.
Likewise, we at Allan Gray lean heavily on our experience of investing on behalf of South Africans since 1974. In investments, performance is the outcome. For this reason, rather than evaluating performance on its own, there is merit in evaluating our commitment to the inputs – the “engine” – that produce this performance, specifically our philosophy, investment processes and people.
In investments, performance is the outcome. For this reason, rather than evaluating performance on its own, there is merit in evaluating our commitment to the inputs … that produce this performance
- A philosophy is a set of beliefs and principles that guide an investor’s decision-making process
An investment manager’s philosophy guides how they think about investing and informs their approach to evaluating investment ideas.
At Allan Gray, our approach to investing is simple: We buy shares we think are undervalued and sell them when we think they have reached their worth. We do this regardless of popular opinion as we are mindful that it is hard to outperform if you simply follow the herd.
One of the factors you should evaluate is whether we have a track record of staying committed to our philosophy through various cycles and delivering alpha over long periods of time, notwithstanding shorter-term periods when this may not be achieved.
- Any philosophy is only as good as its implementation through its investment process
Does the investment manager have a robust investment process in place that puts it in the best position to not only stick to the investment philosophy, but also replicate performance that has been delivered in the past? Is there sufficient rigour in the evaluation of investment decisions? Is the manager structured for success? These questions speak to the robust nature of the process.
While our approach to investing may be simple, our proven ability to apply it consistently and free from short-term pressures is something we believe sets us apart.
- Investment management is a business of people
Having the right people, providing them with the infrastructure to accumulate insights, and putting them in the right positions to make independently considered decisions are crucial for the effective implementation of an investment philosophy and process.
At Allan Gray, we are on our sixth generation of senior investment professionals. Our ability to train new generations of investment decision-makers and effectively manage succession has played a significant role in our ability to replicate our performance track record.
Another key element of trust is alignment of interests. We think clients should ask whether the investment manager itself is structured to prioritise client outcomes and interests. Investors often focus their evaluations exclusively on the investment process, but we believe a company’s structure and ownership are also critical.
We all know that self-interest is an inherent survival mechanism. It is therefore important that an investment manager’s organisational structure is designed to ensure real alignment between its interests and those of its clients.
At Allan Gray, the economics of the business are directly linked to client outcomes by charging performance-related fees. When fund performance is below the benchmark (underperformance), investors are charged less, and when performance is above the benchmark (outperformance), investors are charged more. In addition, we aim to remunerate senior staff in a way that encourages them to behave like owners, rather than managers. These individuals participate in the profits of the firm via long-term ownership schemes, rather than short-term bonuses. This directly links their incentives to clients’ investment outcomes, and avoids short-termism in investment decisions. In short, employees and the company only do well if clients do well – which is just as it should be.
Allan Gray is also privately owned, by the philanthropic Allan & Gill Gray Foundation, and will remain so into perpetuity. This private company status is central to effective implementation of our investment philosophy as it allows the team the freedom to prioritise long-term decision-making, designed to maximise client outcomes, over delivering short-term results.
clients should ask whether the investment manager itself is structured to prioritise client outcomes and interests
Can you trust us to deliver on our promise?
Have we retained a consistent investment philosophy and process, implemented by the right people, over the long term, to deliver a track record of outperformance? And has this been done within an organisational structure that aligns your interests with ours? Your answers to these questions should give you the confidence to evaluate whether your trust in us is indeed well placed.
From our perspective, we do not take lightly the trust you have placed in us to grow your savings. While periods of underperformance can be testing, we hope that our consistent approach and long-term track record will provide the necessary conviction and “proof” points that we can weather the short-term storms and our clients can enjoy the full benefits of what we believe our approach can deliver.