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I recall a fund manager whose fund was struggling at the time, suggesting that an investor should actually be excited about this because it means getting to purchase lower priced assets. This got me thinking whether value investing is applicable in fund/manager selection. Value investing refers purchasing an asset trading at a price lower than its perceived true value with the expectation that the price will eventually rise.

It goes without saying that paying a lower price improves the chances of making a profit. This article tests whether underperformance is an indicator of future outperformance, that is, the presence of pent up value which can ultimately be used in fund selection. This kind of analysis suffers from survivorship bias, as underperforming funds are the most likely to close down, leaving behind funds that perform well. Although this pokes a hole into the value theory, it is no different from what happens when value is applied in share analysis.

One Year rolling returns for the South African General Equity Fund sector are used in this analysis, with the starting point being the 31st of January 2008, a period in which the rolling returns of 19 of the 78 funds turned negative. To illustrate the survivorship, 7 of the underperforming funds subsequently ceased to exist. Chart 1 (below) illustrates how the 19 funds performed over time, specifically looking at the proportion of these funds that end up in the top quartile, and also the proportion of the surviving funds that have positive 1 Year returns.

Chart 1 : South African General Equity Funds which are Bottom Quartile and have Negative 1 Year Returns as at 31 January 2008 and subsequent proportions in Top Quartile & Positive 1 Year Returns

Source: Seed Research using Morningstar Direct (24/07/2018)

The above chart shows that during the first half of 2008, 1 Year rolling returns for some of the funds promptly turned positive while the funds remained bottom quartile before going negative again as the global financial crisis intensified. Post the crisis, towards the end of 2009, 1 Year rolling returns were again positive, and roughly 40% of the initial 19 funds were delivering top quartile performance.

Whilst it is not conclusive that it was value that came into play, the performance showed cyclicality and some of the bottom performers moved to top performers.

Interestingly, performing the same exercise on the top quartile funds as at 31 January 2008 yields fairly similar results to the above chart, as illustrated in Chart 2 (below). Besides the starting points being different (top versus bottom quartile and positive versus negative returns), the subsequent representation amongst the top performers mirrors the chart above, again pointing to cyclicality of performance. Across the whole period, on average 23% of the initial bottom quartile funds deliver top quartile performance, and 25% of the initial top quartile funds also deliver subsequent top quartile performance.

Chart 2: South African General Equity Funds which are Top Quartile and have positive 1 year returns as at 31 January 2008 and subsequent proportions in Top Quartile & Positive 1 Year Returns

Source: Seed Research using Morningstar Direct (24/07/2018)

None of the top quartile funds remain in the top quartile consistently throughout the whole period, and none of the bottom quartile funds are consistently in the bottom quartile. The short-term nature of the returns means this is expected. However, even if you use a longer rolling period, for instance 5 Year or 7 Year, there is no fund within the category that has consistently delivered top quartile performance over the last 20 years for funds with that long a history.

Therefore, it is clearly difficult to purely use value as a strategy to select fund managers. Value should not be separated from the quality of the assets and the manager. Hence, it makes sense to understand the funds both quantitatively and qualitatively in order to make an informed choice.

Kind regards,

Tawanda Mushore

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