Most equity funds that have posted first-quartile returns over a three-year period have not gone on to repeat this sector-topping performance over the following three years, research by FE Trustnet has found.
However, our study also suggests that being at the top of a sector is not enough of a reason to think that a fund’s performance will rapidly turn around and see it fall to the bottom of the peer group.
One of the most common criticisms of active funds is that outperformance tends to be short-lived and followed by a period of underperformance. A common example given is of a fund achieving top-quartile numbers over three years then dropping into the bottom-quartile.
We decided to see how often this was the case by looking at how the quartile rankings of all the funds in 10 major equity sectors have changed over one three-year period to the next.
Source: Finxl
In order to gather these numbers we examined 18 pairs of successive three-year periods, starting with 1 January 1996 to 31 December 1999 and working through to 1 January 2014 to 31 December 2017. And to avoid survivorship bias, this research includes the quartile rankings of the funds that have closed or merged over this time, meaning that around 18,000 data points were reviewed.
The table above shows what proportion of the funds in each quartile stayed in that quartile or moved to a different one over the following three years.
As can be seen, just under two-thirds of equity funds that were in the top quartile over a given three-year period were relegated in the following years. However, the situation isn’t as bad as might be feared: 35.1 per cent – or more than the 25 per cent you’d expect from random chance alone – remained in the top quartile while more than half were in the first or second quartile.
Looking at the bottom quartile shows that the biggest proportion of those funds remained at the bottom of their peer group in the following period, with 28.1 per cent of funds being fourth-quartile over two successive three-year periods. That said, more than one-fifth were able to move into their sector’s top quartile.
We also looked at the proportion of funds that are able to generate top-quartile total returns over three successive three-year periods, or an approximate market cycle. Performance was better than might have been expected here too as 12.5 per cent of equity funds were able to achieve this feat.
Tom Yeowart, manager of Troy Asset Management’s Spectrum fund, said fund managers can often achieve a high level of consistency, but this is often down to having a more flexible approach.
Source: Finxl
“I think it’s unsurprising that most managers will have periods where they look relatively dull. A lot of managers have a rigid process that leads them to certain sectors or companies and they could be more at risk of mean reversion as those sectors or companies move in and out of favour,” he said.
“In some respects, I like managers whose outperformance isn’t because they are obsessed with the benchmark but because of the way they think of investing and their personal character traits. Good performance doesn’t come from fixating on the benchmark but from thinking about the businesses that will do well over the coming three or four years.
“Some managers can display remarkable consistency but it’s incredibly difficult to achieve. When you come across a manager that has achieved this consistency of return, it’s also often something to do with their temperament or personality that makes they successive and dynamically evolve with the times. That consistency is pretty rare but when you do find it, it can be remarkable.”
We also drilled down further into the numbers to find out how things look on a sector level. The above table shows how the first quartile funds in each of the 10 sectors examined fared over the following three years.
This shows that the IA UK All Companies sector was the best performer as more than 40 per cent of its first-quartile members remained at the top of the peer group in the successive period. Only 19 per cent dropped into the bottom quartile.
The IA Global and IA Global Emerging Markets sectors also fared well, with both seeing 35.4 per cent of first-quartile funds hold onto their top ranking from one three-year period to the next. Both of these sectors are one where active funds traditionally struggle.
Turning things on their head, the following table shows how funds in the bottom quartile performed in the following three years.
Source: Finxl
IA Global Emerging Markets is the peer group where investors have had the most chance of seeing a fourth-quartile fund turn their performance around and jump to the top of the sector.
On the other hand, the IA UK Equity Income sector appears to be one where fourth-quartile funds have found it hardest to break free of their position at the bottom of the performance tables. Our data shows that 35 per cent of the periods examined had a fund in the bottom quartile over both.