Read more from Morningstar's Global Equities Week here.
The question on how to find good active equity managers is probably as old as portfolio management itself--and the answers have been, by and large, unsatisfactory. Fund performance data show that only a minority of active funds outperform their benchmark over time. An ever increasing number of European investors are turning to index funds and ETFs to get cheap exposure to market beta. The unsatisfactory nature of the debate on active fund management may, however, also be a result of asking the wrong questions. All too often investors and advisers have focused on short term past performance when picking funds. It could therefore make sense to go back to the basics and look to alternative approaches in search of outperformer funds. What factors should investors be on the lookout for when choosing actively managed equity funds?
We start off with lumping together the three Morningstar large cap categories Europe OE Global Equities Blend, Growth and Value available for sale in Europe including funds of funds. To eliminate short term "noise" we only focus on funds with long-term track records. We set back the clock to March 2003 as a starting point, defining four distinct market cycles along the way:
- April 2003 to end-2007: The era of cheap money drives the international stock markets back towards record highs of the dot-com hey days.
- January 2008 to March 2009: The liquidity party ends. With the bursting of the housing bubble in the U.S., market volatility peaks in October 2008.
- April 2009 to July 2011: The rapid market recovery as of Spring 2009 anticipates the economic recovery of 2010. The intrayear dips in 2009 and 2010 cause anxiety, the upward market trend, however, remains intact until July 2011.
- August 2011: the escalating debt crisis in the euro area sinks through, starting a period of increased volatility. We cut off the data on November 15.
What Does Past Performance Tell Us?
The big picture is a sober one. Of the 923 international equity funds in our sample only 306 delivered a better performance than the MSCI World NR € over time. This represents a success rate of 33.15%. The MSCI index rose at an annualized rate of 4.74% from April 2003 until mid-November 2011. The average fund made just 4.02%, 72 basis points less per year than the index. The picture was even bleaker when looking at risk-adjusted return. Only 189 funds delivered a higher Morningstar risk-adjusted return than the MSCI World, a success ratio of 20.54%. The MSCI World Index delivered 2.58% on average per year versus fund performance of 0.92%.
To drill deeper, we now look at the performance of the best funds, breaking down our sample into deciles. We then check on how the fund clusters performed in the different market cycles. As Table 1 below shows, the first three fund deciles beat the benchmark through all market cycles between 2003 and 2011 on a non-risk-adjusted basis. The first decile returned an annualised 8.49% on average, delivering 375 basis points per year more than the MSCI index. On a risk adjusted basis, only the first two deciles outperformed the index. The first decile delivered annualised 4.99%, and funds in the second decile made 3.01% per year versus benchmark's 2.58%.
From the third decile down, the risk-adjusted performance is consistently below index, as shown in the table. The boxes marked in green show a positive deviation from the index, the red shaded areas show a negative deviation.
Even the Best Funds Exhibit Weakness
Looking at market cycles illustrates quite nicely why past performance as a measure for fund selection can be misleading--even when looking at long-term data. The first fund decile displays a robust risk-adjusted return of 4.99% per year on average. Did this make those funds a good choice all along? Yes and no. The funds of the best two deciles in the upturn cycle 2003 to 2007 proved to be quite resilient outperformers when compared to the peer group. The best performers of the first phase market cycle outperformed the peer group on average in the following market cycles.
However, even the long-term outperformers show signs of strain. Take the latest market downturn: On average the funds of the first decile have trailed the index by cumulated 300 basis points since August 2011. Risk-adjusted, these funds got hammered by 43.53% compared to a 29.08% loss for the MSCI World.
A detailed look at the four distinct market cycles shows that even first decile funds succeeded in outperforming the index on a risk-adjusted level only once, between 2003 and 2007. See Table 2 below, in which the cycles are ordered clockwise (green markings indicate outperformance versus the index, red fields indicate more volatility/less return than the MSCI World).
Essentially, the risk-adjusted outperformance of the first two deciles over the past eight-and-a-half years goes back to their solid performance from 2003 to 2007. It should also be noted that the outperformance in that phase came at a price: top decile funds outperformance was achieved with a volatility of 11.43% compared with MSCI World volatility of 9.27%. Had an investor decided back in 2007 to pick up a three-year top-performing equity fund, he might well have bought more risk than he bargained for.
Do Investment Styles Make a Difference?
Next, we looked at the three investment styles of growth, value and blend. The investment universe of our test is made up of 683 blend, 129 value and 124 growth funds. Since 2003 all three categories have underperformed the MSCI World on average. Growth funds fared best with an annualised performance of 4.57%--17 basis points less than the index. The risk of these funds was, on average, significantly higher, returning 1.28 versus an annualised Morningstar risk-adjusted return of 2.58% for the index. Value funds trailed the index by 34 basis points and by a wider risk-adjusted margin. Both growth and value funds did, however, outperform their peers.
Of all styles, blend funds fared worst, trailing the index as well as the average global large cap equity fund (see Table 3 below)--a result all the more sobering, bearing in mind that this fund group makes up the biggest part of international equity funds sold across Europe.
And What About the Costs?
At the start of the fund selection process investors have little if any knowledge on what the future will bring. But they can capitalise on one thing: knowing the cost of an investment. No matter how good a fund manager may be at running his fund, the costs will inevitably diminish the returns. Are costs a good predictor on future returns? To confirm the correlation between the cost of a fund and its performance, we sorted the 763 funds with data on the maximum annual management fee into deciles, attributing to them non risk-adjusted performance and Morningstar risk-adjusted return.
First findings indicate an inverse correlation does exist between the returns of a fund and its costs. Since we have conclusive management fee data for 763 out of the 923 funds making up our sample, the results are only preliminary. Results seem promising, however. The lowest cost fund decile returned 4.62% on average per year from 2003 to 2011, outperforming the peer group by 60 basis points. Third decile funds came second, adding 4.6% per year, and second decile funds returned 4.29%. The most expensive funds tend to be the worst performers with ninth decile funds faring worst with a mere 3.25% on average, 77 basis points less than funds in the first decile (see Table 4 below).
Cheap funds do not, however, necessarily beat the index. As our findings suggest, dividing the fund sample into deciles by management fee is not a good predictor for outperforming the index. Even the cheapest funds on average trailed the index by 12 basis points per year.
A study carried out by Morningstar in 2010, How Expense Ratios and Star Ratings Predict Success, revealed that heeding a fund's expense ratio paid off every time. In every single time period and data point tested, low-cost funds beat high-cost funds. To see the results, click here.
Conclusions Looking out for past performers can help, but be vigilant about the costs and survivorship bias
Our findings indicate that investors should dampen their expectations on what actively managed equity funds can deliver; one third of international funds registered for sale across Europe managed to beat the MSCI World Index EUR in the long run. Risk-adjusted, the quota was only just above 20%. This makes the search for the outperformers challenging.
What are the best predictors for future returns? Our sample indicates that segmenting fund performance by market cycles helps in explaining past performance a lot better than analysing performance according to the Gregorian calendar. Our data suggest that analysing past performance over several market cycles can be a helpful indicator for future performance. However, since our performance data has not been adjusted for survivorship bias--underperforming funds tend to be liquidated or merged more often than outperforming funds--a more comprehensive analysis on the role of past performance is needed. Morningstar's Stewardship grades can help investors choose funds with longevity: a study carried out earlier this year showed most funds earning high Stewardship Grades were successful in the subsequent years. Specifically, they were likely to survive and provide competitive risk-adjusted returns. Read more in Funds with Principles Make Good Partners.
Evidence is scant that selecting funds by investment style makes sense in Europe when looking for outperformers versus the index. However, growth funds and--to a lesser extent--value funds have outperformed blend funds comfortably. This warrants for a healthy scepticism of the ability of blend fund managers to deliver outperformance. (Note, also, that blend funds dominate the market of international equity funds in Europe!)
Arguably, it makes a lot of sense to look out for the costs of a fund as a predictor for future performance. Our performance rankings show that low cost funds have consistently outperformed expensive funds. In fact, fund costs are one of the key drivers behind the quantitative Morningstar Rating, as well as the qualitative Analyst Ratings which have been available in Europe since 2009.
