Persistence does pay off for top equity performers

Performance track record is the common starting point for both retail and wholesale fund management appointments. Industry publications such as Money Management and Personal Investment as well as invest-ment surveys such as those by Mercer's and Intech provide ample op-portunity to do this.

Clients closely examine fund performance and the managers proudly present past performance track records as an indication of what cli-ents can expect in the future.

But the question remains: are investors

Performance track record is the common starting point for both retail and wholesale fund management appointments. Industry publications such as Money Management and Personal Investment as well as invest-ment surveys such as those by Mercer's and Intech provide ample op-portunity to do this.

Clients closely examine fund performance and the managers proudly present past performance track records as an indication of what cli-ents can expect in the future.

But the question remains: are investors wasting their time trying to pick tomorrow's outperformer by using today's track record? Or worse still, will picking yesterday's heroes lead to inferior investment decisions?

Institutional investors and consultants often pour scorn on the use of past performance in assessing fund managers. References are fre-quently made to either US academic research or a limited number of Australian studies which focus on balanced funds in support of this view.

While closer inspection reveals evidence on persistence in the US is in fact mixed, those in favour of persistence appear to have the up-per hand. Australian research on balanced funds hassuggested evidence of no persistence.

However, there is currently no statistical research published on the persistence of either Australian specialist equity or bond fund man-agers.

Drawing conclusions from balanced fund studies is difficult because fund managers have specifically different strategic benchmark weights, which themselves dominate performance. Measuring a balanced fund manager in terms of relative peer group is unlikely to be appro-priate unless the managers themselves explicitly targets sucha bench-mark.

My research is aimed at addressing the dearth of Australian sector specific research on persistence. It also aims to assess whether the performance persistence found in many US sector studies can be trans-ferred to Australia.

The evidence

There is plenty of evidence available in the William M Mercer data-base of Australian wholesale equity and bond managers. The principle data examined are the three-year periods ending September 1998 and September 1995. Period one is from October 1992 until September 1995, while period two is October 1995 until September 1998.

For the purpose of clarity, performance is defined as excess returns, style-adjusted excess returns and information ratios (IR). Bond funds were not assessed in terms of style adjusted returns.

Equity managers

Results of regression analysis of equity managers comparing period one performance with period two are displayed below, for excess re-turns (1), equity selection returns (2) and information ratios (3). The results of the regression analysis show evidence of persistence at the 95 per cent confidence level for excess returns, selection re-turns and information ratios. While the most significant result is for excess return, the most convincing evidence of persistence is the style adjusted returns result (2). This suggests an outperformanace of 1 per cent in period one would lead to a 0.64 per cent outperfor-mance in period two.

Fixed interest managers

Results of regression analysis of fixed interest managers comparing period one performance to period two are displayed below for excess returns (4) and information ratios (5). Neither of these tables show evidence of persistence. Indeed both show the reverse result that losers in period one are likely to become winners in period two.

An explanation for this rests on the very different interest rate en-vironments during the two regimes. In period one, ten year bond rates start and finish at about 8.8 per cent, but are volatile ranging be-tween 6.8 per cent and 10.4 per cent, whereas in period two they trend down from 8.8 per cent to 5.2 pre cent. The longer duration, more active managers seemed to find the going easier in period two.

Summary

The study found statistically significant evidence of persistence of equity fund performance and indicated reversion of fixed interest fund performance.

The investment implications are clear. Since performance has been demonstrated to persist, performance track record should comprise an important part of the equity manager selection process.

Since recent Australian experience shows past performance can explain about 33 per cent of future performance, it is logical to expect his-torical performance to properly comprise one third of the selection process.

Put simply, these findings provide strong evidence equity outperform-ers are likely to continue outperforming and underperformers will continue to underperform.

Findings of persistence in equity fund returns are consistent with the majority of US research. It is a unique result to the Australian market because it demonstrates the previous findings of no persis-tence in balanced funds simply do not apply to equity funds.

For bonds, the results are consistent with both Australian balanced funds and US bond funds, all three suggest no persistence.

The results in the equities market is important because it suggests the existence of market inefficiencies in Australia which have been documented at length in the US. These inefficiencies are most likely to be attributable to differential information or stock picking skill.

Not only is industry focus on performance when assessing Australian equity managers, it is well supported by contemporary evidence.

Douglas Orr is a quantitative strategist with Tower Asset Management.