The Portfolio Construction Forum Managed Funds Out-performance Report aims to identify funds that have outperformed their peers consistently over time.
This extract presents analysis of wholesale Australian-domiciled multi-sector balanced (green dots on the graphs) and growth funds (red dots) in the Mercer IS survey, which had full data to April 30, 2005 (38 funds in total). Returns are reported on an after-tax and after-management fee basis.
Rolling returns
Rolling average returns are more representative of a fund’s return history than returns over a single time period.
It’s not unknown for fund managers to cherry-pick the best returns to a recent month end when promoting a fund.
Rolling average returns smooth out aberrations in a fund’s returns over time and reveal what has been typical over time.
For example, a three-year-old fund has many three-month returns in its history — after the first three months, there is a new three-month return at every month end, giving 34 three-month returns over the three-year period.
A rolling average three-month return averages all 34 three-month returns over the period, rather than looking at just the most recent three-month return (which could be an aberration and very different to the ‘normal’ returns of the fund).
Similarly, rolling one-year returns is the average of all the one-year returns of a fund over the period examined (for example, 25 one-year returns over the three-year period).
Decile rankings
Decile rankings help to show the extent to which a fund outperforms or underperforms its peers.
Decile rankings are similar to quartile rankings, but give a finer grading.
Academic research has also shown that decile rankings are somewhat consistent over time, particularly at the very top and very bottom deciles (Soucik 2002).
For example, if the average one-year returns of a group of funds range from -25 per cent to 25 per cent, then the range is 50 per cent, giving 10 deciles of 5 per cent (50/10=5). Each fund is assigned to a decile based on the fund’s return.
In our example, a fund with a return greater than 45 per cent is in the first (top) decile.
A fund achieving better than 40 per cent, and up to 45 per cent, is in the second decile, and so on.
It follows that some deciles may have no funds in them (no fund has achieved a return in that decile range), while other deciles may have many funds in them.
The analysis was repeated using two time frames: three years to April 30, 2005, and five years to April 30,2005. The summary table (on page 20) also includes the rolling returns for all funds since inception.
Predicting outperformance
There is no easy way to identify fund managers that will outperform in the future.
Quantitative analysis can highlight those that have consistently achieved higher returns than their peers in the past.
In addition, academic research (Soucik 2002) has confirmed that there is some persistency in top decile and bottom decile rankings over time.
However, Portfolio Construction Forum considers that qualitative research is a necessary complement to quantitative analysis, to consider how a fund’s returns were achieved, and whether the processes, resources, philosophies, and disciplines involved in achieving the returns are likely to be replicable in the future.
Of course, much depends on the skills and experience of the qualitative researcher and the validity of the qualitative research process used.
Deidre Keown is an analyst with Portfolio Construction Forum.
