Focusing on a fund’s ‘base rate’ provides investors with an indication of how successful they will be, according to LGIM’s John Roe, who said doing so will manage overconfidence and maximise potential for gains.
The head of multi-asset funds at LGIM explained that the term ‘base rate’ is derived from the research of US psychologists Daniel Kahneman and Amos Tversky.
In Kahneman’s book Thinking, Fast and Slow he described the concept as ‘base rate neglect’, which is when the brain latches onto one specific example or data point without considering the traits of a broader group.
His research suggests this is often the result of subconscious laziness or, at times, a bid to avoid details which don’t work in the person’s favour.
Roe said being aware of the historic performance of active fund managers – or their base rates - will provide a greater insight for investors in terms of their potential benefits and the costs of choosing them in different asset classes.
“When investing, we believe the use of base rates is essential,” he reasoned. “For example, when deciding whether to invest actively or passively in particular asset classes, as well as what fee is acceptable for doing so, they provide an indication of the likelihood of success for the average investor.
“Individual investors can then adjust that likelihood where they feel they have a genuine edge over their peers.”
The head of multi-asset funds invests across a wide range of vehicles; from active to passive funds and from equity to bond funds. As such, he said it is important to remember that each manager has different objectives and beliefs which will result in varying performance characteristics.
That said, Roe believes using a base rate will provide a “necessary starting point” for investors to select the correct managers for their investment goals without falling victim to overconfidence.
“At a conference in 2015, I asked over a hundred professional investors what they thought was the likelihood of them successfully selecting an active European equity manager,” he explained.
“Around three-quarters of them rated their chances better than 50 per cent. It was a great example of base rate neglect given that only around 20 per cent of funds had outperformed over the previous five years.”
Source: LGIM, 2015
That said, the head of multi-asset funds urged investors to focus on the correct base rate in the first place as, if the sample size chosen is too wide, it can make any subsequent investment decisions irrelevant.
For instance, he said investors looking for a UK equity fund with a specific focus on generating high levels of income should focus on more than just manager performance versus a standard index.
“As more funds become objective orientated and not focused on outperforming an index, then inevitably base rates become more complex to structure as standard indices become less relevant,” Roe also pointed out. “Too often, when people quote historical performance stats of active managers they aren't careful enough about how applicable those are to the current situation.”
The head of multi-asset funds said survivorship bias can also add a greater layer of complexity to collecting base rate data. This is because it will magnify the average returns made by existing funds but will ignore the funds which have underperformed and subsequently closed or merged.
“Fortunately, the S&P SPIVA reports [a bi-annual ‘scorecard’ comparing the performance of active managers and their benchmarks] take snapshots through time to try to limit the survivorship bias impact by assuming that any funds that shut in a period were underperforming,” he explained.
“Fees are generally higher for retail investors than for wholesale and institutional ones, reflecting that individual investors have less buying power.
“Therefore using the SPIVA classifications, fees have a larger impact on mutual fund performance because they include retail investors.”
Administration fees can also negatively impact funds’ returns, according to Roe, as well as the trading costs incurred through buying and selling out of individual holdings.
As such, the head of multi-asset funds will focus on net performance when assessing managers as it provides a more accurate demonstration of the end returns his investors can expect.
“Over longer periods, a similar pattern holds for net returns for equities across different time periods,” he said.
“However, fee compression is a recognised trend in asset management and so it would be misleading to use historic net performance as the base rate; instead we’d adjust it upwards to allow for lower expected fees going forwards, lowering the hurdle for finding the right active manager.”
Many investors opt for passive funds at the expense of actively-managed vehicles, as they believe most managers will underperform over the long-term regardless of asset class or sector.
While Roe said this is largely inaccurate, he said the SPIVA data presents some inexplicable trends among active managers. For example, that small-cap equity managers tend to outperform their larger peers over the longer term.
Performance of indices over 10yrs
Source: FE Analytics
“The fact [these trends] exist is an important reminder to only apply base rates appropriately,” he warned. “Otherwise they can turn from an essential tool into a dangerous trap.”