I’m not sure when I first heard the phrase ‘you can’t eat relative returns’, but it was clearly a while ago, given it is only absolutely (excuse the pun) true in negative market conditions. When the good times are rolling, investors’ perception of risk tends to be skewed towards opportunity cost, as seen in the late 1990s when hitherto top-performing fund manager Neil Woodford was previously widely criticised for not jumping on the TMT bandwagon.
In hindsight, the blip in Woodford’s relative performance (based on his flagship Invesco Perpetual High Income fund) was both brief and inconsequential, compared with the real-terms gains he made for investors after the bandwagon wheels came off.
However, it illustrates a prevailing view in the market that found another expression in Virgin boss Richard Branson’s high-profile 1998 bet with then-Société Générale chief investment officer Nicola Horlick: what students of behavioural finance might call ‘extrapolation bias’ or, more simply, the belief that past performance is a guide to the future.
When Branson launched the Virgin UK Index Tracking fund in 1995, the FTSE All-Share had already enjoyed a pretty good run since the mini-crisis sparked by the UK’s exit from the EU exchange rate mechanism in 1992. By the time he bet Horlick that his tracker fund could outperform her actively managed UK equity fund over the next three years, the index was up about another 50%.
Branson lost the bet, of course. Index-tracking funds by default own more and more of the companies whose share prices have performed best – which in the dotcom bubble tended to be those with anything to do with the emergent internet. When the bubble burst, the tracker funds could do nothing but follow the market downwards. Fund managers like Woodford and Horlick, whose portfolios were based on a more rational assessment of company prospects, did relatively better.
The trouble with focusing too much on relative returns is that ‘outperformance’ when the index is down 30% and your portfolio is down 25% is not going to pay the bills. Equally, ‘underperformance’ when your portfolio is up 25% but the index is up 30% is better than a poke in the eye. But as humans we seem unable to resist making relative comparisons, from fund benchmarks to school league tables, and the yardsticks we use may not always be helpful or even appropriate (a topic for a future column).
With global equity markets at or close to multi-year highs, and company valuations looking stretched compared with historical averages, it is arguably more important than ever for investors to focus on building portfolios of assets more selectively, rather than sticking to those areas that have already run up hardest. While all investment involves some level of risk, there may be more room in the lifeboats of the less crowded vessels.
So is this an argument for active over passive funds, or absolute return over relative strategies, or simply about knowing what you are buying? The active/passive debate is inevitably about relative performance; we often hear how hard it is for active fund managers to outperform in highly ‘efficient’ (for which, perhaps, read thoroughly momentum-driven) markets such as the US. But while few may outperform consistently, many consistently perform, and may have a better record of protecting capital in the inevitable downturns.
Interestingly, there are now no index-tracking investment trusts (the last one, Aberdeen UK Tracker, was rolled into the multi-asset Aberdeen Diversified Income & Growth (ADIG) in April 2017), suggesting the structure is more favoured by active managers who may welcome the ability to take a longer-term view and invest in less liquid stocks (because they do not have to manage inflows and outflows of capital).
Most of the members of the AIC Flexible Investment sector have an absolute return approach, whether through targeting a specified level of return but retaining an equity index for comparison purposes – such as Henderson Alternative Strategies Trust (HAST), which aims for 8-12% a year on a five-year view, but also uses the FTSE World index – or by having a cash-plus benchmark, such as Ruffer Investment Company (RIC), which aims for a capital and income return of twice the Bank of England base rate.
However, there are still many trusts that, to a greater or lesser degree (whether in the construction of their portfolios or the measurement of their returns), have an index-relative mindset. With this in mind, it may please investors to know that, according to the December 2017 AIC Stats publication, the great majority of AIC equity sectors (based on average net asset value returns) beat the relevant index returns over the majority of periods.
As might be expected in an ongoing bull market for equities, absolute performance was positive (in fact, at least in double digits) over one, three, five and 10 years, even in those sectors where the average fund did not beat the index. In fact, the only sector to have negative performance over one and three years was hedge funds.
Suggesting that, sometimes, you can’t eat absolute returns either.
Sarah Godfrey is senior investment companies analyst at Edison Investment Research.