Analysing returns: have you thought of everything?

When selecting an investment manager or constructing a portfolio, the historic returns of a specific strategy or a fund manager are usually a central part of an investor’s analysis. However, while a top-performing fund will always appeal, it is important to look under the bonnet; how a fund manager has generated returns, and in what conditions, is every bit as important as the level of outperformance.

Most investors will be familiar with the conventional metrics for analysing risk and return – return versus a benchmark, for example, or discrete/cumulative return versus a peer group. However, this often reveals little about how a fund manager generates that return. Was it down to one lucky investment? Or perhaps being in the right sector at the right time? Has the manager merely tracked a market index? There are a number of more subtle elements to return analysis that investors may overlook, and it is these ‘unconventional’ factors that need to be taken into consideration when assessing returns.

Long-term consistency

It is always tempting to focus on short term returns, particularly in current fast-paced markets, but to make any real judgement on manager skill, investors need to look at their ability to deliver consistent returns over the longer term. Only through this analysis can an investor judge whether a manager is capable of good performance in a variety of conditions, including protecting against volatility and adverse market movements.

This should also weed out those managers whose performance has been flattered by exposure to certain ‘in vogue’ themes and strategies. Areas such as renewable energy and technology have performed well over the past year, benefitting managers with high exposure to these sectors. However, the question should not be whether a manager has captured this strong performance in the last twelve months but whether they have managed to deliver consistently strong performance for the preceding five or even 10 years.

With that in mind, it is important to recognise whether an actively managed fund has shown sufficient flexibility, adapting to changing market environments, and also whether the manager has stuck to their principles, rather than being supported by obvious market dynamics and short-lived trends.

The influence of trends

When selecting a fund manager, the aim is to identify whether they are good at picking individual companies and building a resilient portfolio. While backing some immediate trends or a single top-performing stock may boost returns in the short-term, it is unlikely to be an effective strategy over the longer term. It is essential to consider the underlying contribution of the constituent holdings when analysing a fund or fund manager, and to fully understand what has driven the overall returns.
A vital component of return analysis should incorporate meetings with the managers themselves in order to fully understand the investment process and get a clear picture of the investment style. We want to understand how the strategy can deliver on its aims and objectives and how it will perform in different market scenarios. It is only by fully appreciating the mechanics of a portfolio that one can identify whether superior performance is deliberate.

This ties in closely with the concept of diversification and the concentration of a portfolio – i.e. whether it is heavily weighted to just a few names or whether there is a greater spread across geography, sector, asset class and style. Another key consideration is the active share of the portfolio, which assesses how much the manager is differentiated from the market or benchmark index – something which can justify paying third-party management fees as opposed to a more passive strategy.

Market biases

The final unconventional factor to consider when looking at returns is the influence of behavioural biases, and the unexpected impact that these can have on performance. All fund managers are subject to irrational human emotions which can influence the way they invest. Examples may include following the herd into ‘hot’ areas, or finding arguments that support their investment thesis, rather than looking at an investment objectively.

It is nearly impossible to identify these traits on the surface, and almost no fund manager is likely to admit their vulnerability, but by analysing the investment process of a fund manager it is possible to see whether they display a more consistent approach to portfolio construction which may be more immune to such behavioural traits. Ultimately, a strong and dependable investment process, with appropriate checks and balances, will help to protect against certain market biases unfairly influencing returns.

It is not enough simply to pick the top-performing fund. Return analysis must be nuanced. Investors need to build an understanding of how a fund manager has generated returns and, most importantly, whether they can be replicated in future.

IMPORTANT INFORMATION
This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance

Smith & Williamson Investment Management LLP
Authorised and regulated by the Financial Conduct Authority
Smith & Williamson Investment Management LLP is part of the Tilney Smith & Williamson group.
© Tilney Smith & Williamson Limited 2022

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