The current investment environment provides a test of patience for investors, particularly when one is not prepared for periods of underperformance. It is normal for funds to underperform as performance goes through cycles.

Knee-jerk reactions fuelled by emotions of fear and greed often result in investors not achieving the full investment cycle returns from the funds they invest in.

Fund total returns widely published by independent data providers on fund manager websites and marketing materials reflect a buy-and-hold strategy over the investment period. However, some investors, because of fear and greed, do not follow this strategy, but rather attempt to time the market, selling underperforming funds and buying those that are outperforming. This behaviour can be harmful, particularly if investing in a fund that has already reached the peak of its performance cycle. Chart 1 (below) illustrates such investor behaviour, and Chart 2 illustrates the cost of trying to time the market.

Chart 1: Investor Behaviour Fund Flows Follow Short-Term Performance

1 Year Rolling Return Quartile Rank and Monthly Fund Flows

Chasing Performance = Greater Inflows When Top Quartile Performer

Fund A is a South African Multi-Asset High Equity Fund. Inflows and outflows are closely linked to the short-term performance illustrated by the 1 year rolling return quartile rank.

Source: Morningstar Direct (10 July 2017)

Chart 2: Investor Behaviour – The Cost of Chasing Performance

Switching from High Equity to Low Equity During Period of Underperformance

Leading up to February 2009, the Multi-Asset High Equity Category fell -15% compared to the Low Equities -1%. A switch at the time to the Low Equity to minimise losses would have seen a subsequent 3 year cumulative return 16% lower in the Low Equity Category.

Source: Morningstar Direct (10 July 2017)

Since cash flows result in a different experience for the investor compared to the actual fund total return, a dollar-weighted return (investor return) gives a better indication of how the average investor performs over time. When the investor return is lower than the fund total return, it implies that more investors participated in downside returns and less in upside returns. This is common when investors chase returns and pile flows into funds at the peak of their performance and can also be exacerbated by not selling a losing fund. Investor returns are greater than total returns when there is more upside participation by investors.

A global report published by Morningstar showed a 5 Year return gap between investor and total returns up to the end of December 2016 ranging from -1.43% to +0.53% (negative indicates lower investor returns). Results from the US and Europe where data sets are more reliable show the challenges that investors face because of the unfortunate timing of cash flows, generally resulting in lower investor returns. The more volatile Funds and higher cost funds tend to have the larger return gaps. A sample of local funds in the Multi-Asset categories over a 5 Year period gives a mixed bag of results as shown below. Wide negative return gaps on some funds illustrate how investors lose out in comparison to overall fund returns.

Chart 3: Selected Large South African Multi-Asset Fund Investor Returns Compared to Total Returns

Difference Between Investor and Fund Total Returns (%)

5 Year Local Multi Asset Fund Returns

Source: Morningstar Direct (10 July 2017)

It is key for investors to select appropriate funds aligned with their investment objectives from the onset and then stick with these Funds through cycles. At Seed, we are guided by a well-defined investment philosophy and rigorous process which means our fund and manager selection is in line with our long-term strategy. This ensures that our portfolios behave as expected, including periods of short-term underperformance. Sticking with such a strategy over the long term is key to attaining investment objectives.

Kind regards,

Tawanda Mushore

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