Does short-term investment performance matter? September 2017 Most clarity clients invest for long-term growth, whether this is in a SIPP, ISA or taxable investment funds. In line with this long-term view, when selecting funds for our buy list, the clarity investment committee prefers longstanding, experienced fund managers who have encountered a wide range of stock market and economic conditions over the years. In the table below, we look at how the main investment sectors have performed in terms of total return (investment growth plus reinvested income) over the last 1, 3, 5, 7 and 10 years. Whilst we can look further back than that, many funds and their managers do not have that length of history, so distortions are more likely to creep in. The top performing sector for each time frame is highlighted in green and the lowest performing sector highlighted in red. (Source for all table figures: FE Analytics, August 2017.) cumulative annual performance (%) to 31 July 2017 1 year 3 years 5 years 7 years 10 years Asia-Pacific ex Japan 23.51 46.47 75.88 88.66 122.17 China/Greater China 32.96 58.51 105.57 82.88 117.21 Europe ex UK 24.04 47.45 109.78 111.35 87.94 Flexible Investment 11.82 26.19 53.04 67.37 57.55 Global Bonds 2.73 15.88 19.04 29.29 74.30 Global Emerging Markets 24.20 36.70 49.42 49.96 78.25 Global 16.89 42.19 81.32 97.09 89.63 Japan 17.80 57.28 106.36 102.81 84.60 Mixed Investment 20-60% Shares 8.29 19.90 38.61 51.64 52.47 Mixed Investment 40-85% Shares 11.62 27.08 53.25 68.19 66.50 North America 16.56 63.00 124.06 170.79 174.20 North American Smaller Companies 17.93 62.49 128.63 173.43 203.80 Property 4.58 20.03 35.00 46.22 4.09 Specialist 9.10 20.01 35.48 45.44 49.89 Sterling Corporate Bond 3.29 18.59 29.59 48.74 64.64 Sterling High Yield 8.80 12.92 34.58 50.52 74.42 Sterling Strategic Bond 4.01 13.50 27.54 45.60 63.27 Targeted Absolute Return 3.12 7.38 17.70 23.14 35.43 UK All Companies 16.51 26.27 70.72 92.96 72.66 UK Equity Income 13.45 24.75 69.53 94.77 72.26 UK Index-Linked Gilts 4.89 35.76 44.23 81.09 117.22 UK Smaller Companies 30.44 44.48 118.36 169.13 120.82 Average performance 13.93 33.04 64.90 81.41 85.61 1
Looking at the cumulative performance statistics in the table on page 1, we can see that the best-performing sector over 5, 7 and 10 years has been North American Smaller Companies, with the broader North America sector fairly close behind apart from over the 10-year timeframe. Also performing well over the last 7 years is UK Smaller Companies, although investors who have held the sector for 10 years will have had a considerably lower return. Overall, smaller companies tend to outperform their larger siblings as many of them are growing strongly and may add 50-100% in share price valuation over a year. For instance, shares in UK Oil & Gas (held in clarity buy list fund Marlborough UK Micro-Cap Growth) drifted slowly down by around 50% over the last year, before shooting up to over 400% on news related to an oil discovery (see chart below). However, at much the same time, shares in plant improvement specialists, Plant Impact (also held in Marlborough UK Micro-Cap Growth fund), lost almost half their value as the company suffered from weak sales resulting from poor credit availability for customers in Brazil: 2
On the principle that elephants don t gallop, larger companies tend to make proportionately smaller gains and losses in their share prices, as illustrated by the figures for the UK All Companies and UK Equity Income sectors in the table on page 1. The data for the North America and North American Smaller Companies sectors are fairly similar to each other, anecdotally because many US companies export a relatively small percentage of their output as they have such a large domestic market. China has performed fairly well, but has suffered from fluctuating waves of enthusiasm and antipathy. We look at the relative volatility of the sector below. Investors have also tended to blow hot and cold on Japan, with older market participants often somewhat wary having been burnt in the market collapse of the nineties, followed by the lost decades. Turning now to other asset classes, property has had a very mixed experience over the last dozen or more years. Investors seemed to be on a one-way ticket before the financial crisis, with property prices increasing rapidly. However, boom turned to bust and those who bought at the peak have gained perhaps 4% over the ensuing 10 years or so, although earlier and more recent investors have seen decent returns. We like physical commercial property as an asset class, valuing it both for its dependable income and relatively low correlation with other asset classes (although this does not apply to residential property or property shares). Bonds have also performed reasonably well over most of the periods shown above. As with physical commercial property, bonds as a whole are good diversifiers in a well-balanced portfolio and provide a decent level of riskadjusted income with little in the way of growth. Are they exciting? No; nor are they meant to be. High-yield bonds are more correlated with equities, as they are issued by less resilient companies and so are generally more volatile. Bonds and property generally obtain most of their total return from reinvested income. Targeted absolute return has generally been the worstperforming sector, just pipped for the wooden spoon over the last year by global bonds and undershot at the long end by property, as mentioned earlier. The overall objective of this type of fund is to make positive returns in all market conditions (usually over a rather imprecise period like a market cycle ); in other words, to avoid losing money for investors who may depend upon regular income. Most are highly complex and use techniques that are not easy to understand. This is not a sector we would recommend for most clients, although we have one simple UK equity fund (Henderson UK Absolute Return) in our most cautious model portfolio. How about volatility? Investment theory tells us that assets with low volatility give low relative returns. Think cash: leaving money in the bank tends to result in low returns as its value does not fluctuate from day to day. Cash rates will often not keep pace with inflation, so the real return in spending power may be negative, but the headline value of a fixed deposit will remain the same. Prices of investment assets, such as equities, bonds and property, are far more linked to what other investors are willing to pay. This introduces volatility to the equation, as interest rates, ratings, supply and demand, together with sentiment in terms of fear and greed come into play. In general terms, property is likely to be the least volatile, with bonds slightly higher up the scale and equities the most volatile. Within each of these asset classes there are also degrees of volatility. Leaving out property, bonds are affected by interest rates, ratings, the coupon (i.e. the stated income paid on that particular bond) and the period until maturity. Equities are affected by many factors, such as the country of registration, the size of the company, its reputation and dividend history, its type of trade, investor expectations and, again, supply and demand for its shares. We have seen two significant trends in recent years: the great increase in index tracking and the rise of multi-asset funds. The former can considerably increase volatility as it concentrates investment in certain sectors and companies. For instance, the FTSE All-Share Index includes 26% in the Financials sector, and HSBC is the largest company in the Index at almost 6%. Multi-asset funds can be used to choose a level of volatility by spreading investment across various asset classes. However, building a portfolio of multi-asset funds is fraught with hazard as, if the managers of these take similar views, the portfolio could become very overweight in certain sectors, greatly increasing risk and potential volatility. Targeted absolute return funds were created in reaction to large and sustained falls in global stock markets and attempt to overcome fear of loss amongst private investors by aiming to make positive returns over a stated, often rather vague, period. Whilst some such funds have achieved this aim, others have not. What most of them share is a very opaque structure incorporating numerous different transactions and strategies. 3
annualised volatility to 31 July 2017 1 year 3 years 5 years 7 years 10 years Asia-Pacific ex Japan 9.67 14.01 12.77 14.19 18.78 China/Greater China 11.45 17.27 15.48 16.44 21.52 Europe ex UK 10.64 10.67 10.96 14.08 18.05 Flexible Investment 4.43 6.93 6.82 8.17 11.25 Global Bonds 4.23 4.83 4.53 4.27 5.63 Global Emerging Markets 12.46 15.52 14.19 15.47 19.77 Global 5.76 9.26 8.86 10.09 13.33 Japan 10.57 12.08 12.01 12.85 14.61 Mixed Investment 20-60% Shares 3.75 5.23 5.06 5.39 7.01 Mixed Investment 40-85% Shares 4.60 6.76 6.55 7.40 9.83 North America 7.14 11.50 11.23 11.57 14.48 North American Smaller Companies 8.72 13.30 13.01 14.30 17.53 Property 2.33 3.36 3.03 3.74 8.11 Specialist 6.19 8.71 8.00 8.81 11.31 Sterling Corporate Bond 5.85 5.46 5.12 4.99 5.74 Sterling High Yield 2.79 4.65 4.28 5.81 9.07 Sterling Strategic Bond 3.99 3.77 3.59 3.85 5.52 Targeted Absolute Return 1.52 1.91 2.06 2.25 2.95 UK All Companies 6.12 9.20 9.21 11.09 14.54 UK Equity Income 6.38 8.54 8.65 9.83 13.14 UK Index-Linked Gilts 13.33 11.64 9.92 9.40 9.38 UK Smaller Companies 8.33 10.55 9.65 11.43 15.71 Average volatility 6.83 8.87 8.41 9.34 12.15 The lowest volatility sector for each time frame is highlighted in green and the highest volatility sector highlighted in red. Source for all table figures: FE Analytics, August 2017. 4
What can we learn from the volatility table? Looking at the table on page 4, the Targeted Absolute Return sector has the lowest volatility over all periods, as it is designed to have. However, when we compare this with the performance table at the top, we find this sector has had the poorest returns in three out of the five periods. The bond funds also tend to have below average volatility, together with below average performance. This is as we would expect, as they often add stability to a balanced portfolio for which the compensation is lower performance. Turning to the higher volatility sectors, China/Greater China has well above average volatility and we can see that its performance has also tended to be above average. However, performance has only partially compensated for the additional volatility suffered, as the North American Smaller Companies sector has taken the performance crown in the three longer periods, and been very close over one more, with significantly lower volatility. As the Chinese stock market is unusually volatile, we recommend Invesco Perpetual Hong Kong & China fund only for our higher risk model portfolios, whereas the Schroder US Smaller Companies fund is incorporated in a wider range of models. Does short-term investment performance matter? Returning to the question we originally posed, whether we should take much notice of short-term performance statistics, we would argue not. Looking at the performance table at the top, the sector with the best 1-year returns is China/Greater China, but this is the only time it features in the top position. Similarly, Global Bonds is the worst-performing sector, but does not feature in this position over any other period. In the volatility stakes, UK Index-Linked Gilts has the highest volatility over the last year, but does not come anywhere near over the other periods. Targeted Absolute Return, however, does have the lowest volatility over each period but, one would argue, this is as it is designed to be. The last 12 months has been an unusual period, admittedly, encompassing the fallout from the EU referendum, President Trump and considerable uncertainty over the outcomes of the Dutch and French elections. But can we not say that almost any 12-month period has its shocks and uncertainties? This is without looking at even shorter periods. Stock markets are increasingly driven by quarterly company earnings reports, with shares often suffering egregiously if earnings and profits forecasts are undershot - or even, sometimes, if they are hit but analysts were hoping for more. Balance in all things At clarity, we aim to create portfolios balanced between the three major asset classes of equities, bonds and commercial property. The balance between these asset classes, equity regions and individual funds is reviewed on a regular basis to ensure that our model portfolios retain a suitable balance between risk and potential reward. Within the asset classes, we use different types of strategy, such as growth- and income-focused funds, for a similar reason. The investment advice process starts with asset allocation, as research (and our own experience) shows that this accounts for most of the performance of a portfolio. We endeavour to maintain a fairly compact buy list, yet to offer a good range of funds covering the major asset classes and some more niche funds to enhance diversification. We like our buy list fund managers to have a fairly long investment horizon, usually 3-5 years. We are relatively patient with the managers, as long as we believe they are following a consistent investment process and there has been no paradigm shift in the market (rare, but it does happen). As we tend to use fund managers with a great deal of experience and a robust, well-documented investment process we take a relatively sanguine view of short-term underperformance. We aim to meet annually on a one-to-one basis with most of these managers, or a senior member of their team, to discuss a wide range of factors including the fund s investment process, performance, and the outlook for the fund and sector. Often this will be same person year after year and this continuity builds a valuable relationship. Risk warning: The past is not necessarily a guide to future performance. The value of your investment and the income from it can fall as well as rise and is not guaranteed. You may not get back the full amount invested. Our views are based upon our understanding of current legislation in England and Wales. Levels and bases of, and reliefs from, taxation are subject to change and their value to you will depend upon your personal circumstances. You should not act on any of the information without seeking professional advice. clarity Ltd 2017 clarityglobal.com clarity Ltd is authorised and regulated by the Financial Conduct Authority (FCA). 5