Diversified funds’ performance – how did they do that?
Comparing managed funds can be confusing because, contrary to current practices, evaluating performance is not all about returns – it’s also about how much risk you as the end investor took to get there. So how can you measure your fund’s level of risk? Below are four broad indicators to watch for:
- Exposure to growth assets – this is the most common method of quantifying risk. However, this does not reflect the riskiness of specific underlying investments. Moreover, there is no universally accepted definition of a growth asset.
- Volatility – this describes variability in the value of historical returns. Importantly, volatility does not measure the likelihood of total loss.
- Scenario Analysis – involves measuring portfolio performance during defined historical periods and simulated events. These observations provide an indication of a fund’s risk profile.
- Exposure to illiquid assets – higher exposure to these assets is typically associated with increased risk. This is because illiquid assets are vulnerable to not being redeemable for extended periods, particularly during episodes of market stress. During such episodes, a funds’ allocation to illiquid assets may grow to an unintended extent, as these cannot be offloaded while at the same time the market value of more liquid assets falls significantly.
Evaluating the performance of traditional diversified funds is inherently two parts art, one part science. Being aware of the pitfalls can help to make the process of comparing funds more reliable. Below is a three-step process that can assist you.
- Identify an appropriate peer group – funds with broadly similar structural profiles enable comparisons to be made on a like-for-like basis. Also, a consistent basis for consideration of tax and investment management fees is important to further ensure that comparisons are fair. Comparisons between goals-based funds and traditional diversified funds should be avoided. This is because goals-based funds are fundamentally different to traditional diversified funds in terms of their investment objectives and portfolio construction.
- Identify comparable risk levels – despite risk measurement being an imprecise science, fund evaluation is likely to yield more accurate results when comparing funds with similar asset allocation, performance and volatility profiles.
- Measure performance over time, not at a point in time. This will negate the impact of once-off influences. Moreover, performance records are generally presented with the qualification that past performance should not be solely relied on as an indicator of future performance. Fund track records provide far greater analytical insight when they are overlaid with a consideration of the drivers of performance and whether these are likely to be sustainable over the forecast horizon.
Time horizons are an overarching consideration in the managed fund evaluation process. Evaluations made in respect of one- and three-month periods should be avoided. This is because performance over these periods is typically irrelevant for evaluating fund managers who typically make their decisions in the context of a three- to five-year timeframe.
Measuring risk is an imprecise science. As ancient Greek philosopher Aristotle once said, there are instances when precise accuracy is not always possible. Risk measurement is one such case, as no single metric can summarise the risk associated with an investment. Ultimately, all risk measurements have limitations and are at best general approximations.
To read the full article, please click here.
Stephen Flegg AMP Capital Portfolio Manager, Multi-Asset Group
Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. © Copyright 2017 AMP Capital Investors Limited. All rights reserved.