INVESTING
30 April 2019
VALDON THERON Head: Institutional Business, Prudential
T
he limitations of past investment performance are well noted. However, the reality is that investment flows continue to follow relatively short-term fund performance. An investment return between two specific dates, long-term or not, tells us little about how and when the performance was delivered. We would ask that, in judging a fund’s performance and whether the managers have delivered on what they promised, investors look at the performance journey of a fund over time and through different market conditions, rather than a frozen, point-in-time snapshot. Rolling returns provide an improved measure, allowing investors to see the long term in more detail by using more data points. The chronological view that rolling returns provides can reveal important information on how a fund has ‘behaved’ over various market cycles, and ultimately whether investment results have lived up to the manager’s stated investment approach. Rolling active returns, namely portfolio returns above or below a benchmark, can provide significant insight into the consistency of a manager’s outperformance, an important consideration in assessing investment skill.
Judging asset managers: The journey of past performance
Importantly, successful investment is not about being ‘correct’ all the time. What matters ultimately is how much money you make when you are correct versus how much you lose when you are wrong. A frequency distribution is an effective graphical way to distinguish between frequency and magnitude of active returns and observe a manager’s ‘alpha profile’. In other words, we can see how often an investment manager produces positive and negative active returns, and how large they have been, across various periods. The graph shows the frequency distributions of rolling one-, three- and five-year active returns for Prudential’s Core Equity Composite for the 10-year period ending 31 December 2018. The number of observations (frequency) is shown on the vertical axis, while the active return outcomes, grouped into 2% intervals, are shown on the horizontal axis. From this we can see the following: • Underperformance over rolling one-year periods can and will happen. However, the frequency and magnitude of outperformance (observations to the right of the 0% vertical line) more than offset the instances of underperformance. This is in keeping with Prudential’s approach of compounding relatively
GAVIN RALSTON Head of Official Institutions and Thought Leadership, Schroders
E
ven though China is the world’s second largest economy, Chinese stocks have historically been underrepresented in global benchmark indices. This is because for a long time China A-shares, stocks listed in mainland China, were difficult for foreign investors to access due to restrictions on capital flows. A major shift happened in 2014 with the introduction of the Shanghai-Hong Kong Stock Connect, which allows qualified foreign investors to trade eligible A-shares without the need for a local Chinese licence. Index providers have taken notice of this liberalisation. Last year MSCI added A-shares to its suite of global benchmark indices. Initially, only 5% of the full market capitalisation of A-shares was included. However, MSCI recently announced that the inclusion factor would quadruple over the course of 2019, to reach 20%. Currently, A-shares are only around 0.8% of the MSCI Emerging Markets Index, but this could rise to more than 14% after full inclusion. Nonetheless, there is no clarity on when or if A-shares will be fully included. As the weight of A-shares grows, investors will have to decide how to access this part of China’s equity universe, and how much to allocate to onshore equities. We believe that rather than waiting for index providers to raise the weighting, investors should consider a
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small gains over time. • Underperformance over rolling three-year periods has occurred far less frequently: in only three out of 85 observations. Also the combined frequency and magnitude of outperformance significantly offset the relatively small instances of underperformance. • Over rolling five-year timeframes, all active returns are positive as a result of prudently ‘winning more than losing’ over the shorter time periods. • Notably, there are more small gains and losses (in the 0%-2% and 2%-4% ranges) over time than larger gains and losses (over 4%). This is also in
line with Prudential’s approach of being mindful of the size of potential losses. • By compounding relatively consistent outperformance over time, the Prudential Core Equity Composite has outperformed its benchmark by 1.7% p.a. since inception in 2004 (gross of fees). So next time you’re judging fund manager performance, we encourage investors to look beyond short-term, point-in-time returns measured to the most recent date, and consider the longer journey taken to achieve those returns over time.
A new approach to investing in emerging markets separate satellite A-shares allocation, in addition to a global emerging markets mandate. Such an allocation would allow investors to access a much larger portion of the A-shares market. The broader opportunity set is necessary to reap the benefits of the compelling characteristics of the A-shares market as listed below. An inefficient market The A-shares market is dominated by retail investors, who in 2018 accounted for 86% of the total trading volume. This has made the market volatile and susceptible to wild swings in sentiment. In late 2014, the CSI 300 Index started to rise fast. Hoping to jump on the bandwagon, retail investors began opening new stock trading accounts. At one point in 2015, more than four million new accounts were opened every week. Consequently, stock prices became detached from fundamentals, driven by speculation. Inevitably, the bubble burst in June 2015 and the index fell close to 50% over the following months. Fertile ground for active managers Given the inefficiencies, the A-shares market has been a fertile ground for active managers. Over the last five years, the median China A-shares manager has been able to earn an
annualised excess return of 6.3% after fees. This is an exceptional figure by global standards. Median excess returns have been close to zero or negative in most global equity categories over the same timeframe. The high level of potential alpha means that investors can earn good returns even if the market as a whole does not deliver. The correlation argument The A-shares market can also be an important source of portfolio diversification. Historically, the onshore MSCI China A Index has had half the correlation with global equities than the offshore MSCI China index. As the share of A-shares is gradually increasing in global benchmarks, the diversification benefit will decline over time as A-shares become more integrated with the global investing universe. Important Information: Past performance is not a guide to future performance and may not be repeated. Countries mentioned are for illustrative purposes only and not a recommendation to invest. For professional investors and advisers only. The material is not suitable for retail clients. We define ‘Professional investors’ as those who have the appropriate expertise and knowledge e.g. asset managers, distributors and financial intermediaries. Schroders Investment Management Ltd is an authorised financial services provider FSP No: 48998, registration number: 01893220
