How to identify SA’s top equity fund managers

CAPE TOWN – For most investors, the single most important thing when choosing between unit trusts is past performance. The funds that have generated the highest returns are the ones that attract the most attention.

However, there are two problems with this approach. The first is that many investors don’t take a long enough track record into account. Returns over one year may look good, but has the fund manager shown the ability to generate out-performance over sustained periods of time and through different market cycles?

Secondly, there is little consideration given to the risk that a manager has taken on to generate that return. This is particularly true over shorter time frames, where some risky positions may pay off handsomely. However, will the manager be able to protect those gains in the long run?

One way of assessing a fund’s risk is to use the Sharpe ratio. This essentially looks at a fund’s returns in relation to its volatility. The higher the ratio, the better the balance between risk and reward.

The one shortcoming in this calculation is however that it assumes that all volatility is risk, even if that volatility is to the upside. Equity investors in particular are not that concerned about big positive moves. What they actually want to avoid is downside volatility.

For this reason, the Sortino ratio is a better measure of how well a fund is managing its risk. The Sortino ratio uses the same concept at the Sharpe Ratio, but only takes downside volatility into account.

What you get therefore is a ratio that shows you how much upside performance a fund is able to generate relative to its downside risk. This is a very good way for investors to set a sense of how well fund managers are allocating their capital.

Top equity funds

The below table from Morningstar shows the top general equity funds in South Africa over the past three years to the end of February based on their Sortino ratios.

SA general equity funds to 29 February 2016
Fund 3 Year annualisedtotal return Sortino Ratio (annualised)
36ONE MET Equity Fund A 17.08% 2.26
Nedgroup Investments Private Wealth Equity Fund A 17.48% 1.72
Fairtree MET Equity Fund A1 16.62% 1.6
Truffle MET General Equity Fund A 15.56% 1.52
27Four Shari’ah Active Equity Prescient Fund A1 14.28% 1.46
Old Mutual Albaraka Equity Fund A 13.77% 1.4
Investec Equity Fund R 15.63% 1.38
Mazi Capital Prime Equity Fund A1 14.19% 1.38
IFM Technical Fund 14.55 1.35
Mergence Equity Prescient Fund A1 14.16% 1.33
Sasfin MET Equity Fund A 12.94% 1.31
Prime General Equity Fund B 12.53% 1.28
Stewart MET Macro Equity FoF A 12.68% 1.25
Old Mutual Investors Fund R 14.00% 1.23
Sanlam Select Optimised Equity Fund B4 12.74% 1.21
FTSE/JSE All Share Index 10.90%
SA general equity fund category average 8.64%

Source: Morningstar

The first point that must be made is that, largely, the top-performing funds over this time period also show high Sortino ratios. However, this is not exclusively true. Of the top 15 funds by performance, 11 are on this list.

Where a fund shows high performance over a three year period, but a high Sortino ratio, that is an indicator that those returns have not been stable. This doesn’t automatically mean these funds are badly managed, but one needs to understand why this would be the case.

For instance, the Investec Value Fund shows an annualised return of 11.77% over this period. However, its Sortino ratio is 0.53.

This automatically tells an investor that there must have been some big drawdowns along the way, and certainly that is the case. The Investec Value Fund went through a long period of severe under-performance with some big setbacks for investors. It has however gone through a recent period of delivering exceptional returns.

Some may understand the philosophy behind the fund and be comfortable with it, but certainly this kind of volatility is not going to suit everybody. The majority of investors may be more at ease in a fund that has been better at holding onto its gains.

As the table shows, the 36ONE MET Equity Fund has been an exceptional example of exactly this. Its Sortino ratio is way ahead of any of its peers, pointing to how little negative volatility it has experienced.

This won’t always be the case, and all funds go through periods of weaker performance, but a Sortino ratio this high in an equity fund does point to some exceptional management. It should give investors a great deal of confidence that their money is being prudently looked after.

A final point worth noting is that the fund with the lowest annualised return on the above list is the Stewart MET Macro Equity FoF. This is something of an endorsement for diversification.

In its portfolio this fund holds many of the other funds on the list, including the 36ONE, Fairtree and Investec funds, which obviously has a big impact. But the benefit of having different drivers of returns means that risks are reduced and although returns may be lower, there are likely to be fewer shocks to the investor.