Past performance is not indicative of future performance

This familiar disclaimer is generally treated as a warning label. Do not assume an investment will continue to do well in the future simply because it has done well in the past. On the surface it may seem counterintuitive, but investing is not an exact science and performance alone does not always reflect manager skill. It may be driven by luck, a particular market cycle, or a structural bias in the manager’s approach. Do not forget, the phrase also contains a second meaning — a potential investment opportunities label. Do not discount an investment simply because it has done poorly recently. It could improve.

For instance, managers in the ASISA High Equity Category, on average, held about 68%1 in equities over the past six years. This period has included the Covid pandemic, the Russia-Ukraine war, the conflict in Gaza, and global trade tensions. Although managers with structurally lower equity exposures may have appeared to outperform during equity market drawdowns, it may have largely been due to market conditions rather than investment skill.

Rewards based on past performance

The plethora of industry awards puts a spotlight on performance, which is only one aspect of investment analysis. These awards acknowledge a job well-done and that a fund manager has added value for investors. However, winning an industry award is akin to winning an Oscar for a great film — it is not necessarily an indicator of whether the same actor, screen play writer or director is going to win again. There are several great actors or directors who have never won an Oscar, but their movies are consistently good.

Our Diamond Awards, are differentiated in that they recognise strong past performance of single managers BUT, importantly, there is also a qualitative link in our awards. Firstly, the Diamond Award rankings are calculated over 5-years using 30 different return, risk, and risk-adjusted return metrics, some of which are proprietary. Five diamonds are awarded to the top 15% ranked funds in an ASISA category and one diamond to the bottom 15% with a spread in between. We also recognise long-term performance in a single category with our 10-year award. However, for a fund to be considered, it MUST be rated Silver or Gold by our manager research process, and the same portfolio manager or team must have managed the fund over the past 5 years. In addition, the methodology applied, as outlined above, is fully transparent.

In order to be meaningful, performance ranking methodologies and performance analysis needs to consider that ASISA and Morningstar categories are not homogenous. This means that funds could have a variety of investment approaches with varying objectives. One of the sectors that best demonstrates this issue is the South African Multi-Asset Income (MA Income) category. Some funds in this category have ‘cash plus’ mandates with little to no duration, others have low duration, and some funds with more aggressive approaches, have a duration of more than 3 years. Furthermore, some managers in the MA Income category have allocations to property, equity and foreign assets.

Again, performance ranking awards should be viewed with caution.

Qualitative ratings are the sustenance of our research process

While the Diamond Awards recognise past performance, our qualitative ratings process is an opportunity to assess the potential for strong future outperformance. We have a time-tested investment and manager research process that has one prime focus — to identify the funds that stand the best chance of being competitive in their respective peer groups based on the assessment of several qualitative and quantitative factors. Qualitative aspects include an assessment of the ‘people’ (portfolio managers and analysts) behind the investment decisions. We assess managers from different perspectives including their philosophy, process, portfolio construction, integration of Environment, Social and Governance, and their approach to risk management. We also consider performance on an absolute and relative basis.

We have a team-based approach whereby our investment team can independently score a fund from 1.0 (lowest) to 5.0 (highest), with the average score representing the DFM house view. This indicates our conviction level of a fund’s competitiveness in a peer group (alpha vs peers) or of the fund outperforming an appropriate benchmark (alpha vs benchmark).

In general, we have higher conviction in managers with experienced and diverse team inputs. We also believe that highly rated managers exhibit strong alignment of philosophy, process and portfolio construction. The resultant portfolio and the risk taken makes sense given the manager’s investment approach. We expect these managers to be competitive in their respective peer categories, potentially exceeding our alpha expectations.

Rating changes — behind the process

With our continuous qualitative reviews of managers and frequent portfolio management updates, our intention is to identify the potential for underperformance in advance.

While underperformance relative to peers or a benchmark may trigger a deep-dive analysis, most of our ad-hoc reviews are on the back of changes in qualitative factors. Examples include significant people changes in the investment team or executive, or changes to a manager’s investment approach and process.

We assess the 3-year and 5-year Diamond Rankings of underlying funds within portfolios or approved funds on a quarterly basis. This could trigger further analysis of the risk, return and risk-adjusted components of the ranking itself, amongst other assessments. If an outcome is outside of expectations, we gather additional information from the manager, such as the latest holdings, attributions over both the short and long-term, buy and sell decisions etc. This is discussed in detail with the manager and our team (both analysts and portfolio managers) may then recommend that a full manager due-diligence process be completed.

We point out that this process is iterative with various potential actions that can be taken by our investment team, examples of which are shown in the diagram that follows

One of our investment beliefs is that there is always something new to learn, whether it is about our managers, opportunities or market dynamics. A premise to our investment approach is that it is difficult to time markets and hence it will be difficult to time entering and exiting a fund. We therefore put more effort into understanding a manager’s source of alpha and their correlations to other managers when constructing portfolios.

Diamonds vs Gold — a low correlation is expected

We reiterate that our qualitative ratings are an expectation (forward-looking) of a fund’s alpha relative to peers over an appropriate period. We are cognisant, however, that the market environment can impact a the fund’s performance during that period.

Subsequently, we expect Silver or Gold-rated managers to go through periods of underperformance, and for Bronze-rated managers to go through periods of outperformance. For these reasons, we expect little correlation between Diamond Rankings and qualitative ratings. This is demonstrated in the table below which provides the 3-year Diamond Rankings relative to our latest qualitative ratings for funds in the South African ASISA High Equity Category, that include a global allocation.

As expected, there is a spread in performance with Gold-rated funds achieving a variety of Diamond Rankings. The same outcome can be seen for Silver and Bronze-rated managers. We highlight that the period selected, and an understanding of the ASISA Category itself, is important context when assessing the Diamond Rankings. For example, there has been a proliferation of DFM and adviser-run multi-managed funds that can make the results murky.

In conclusion

We invest with a future-facing lens. While performance matters, it is just one dimension of our extensive due-diligence process. We are foremost qualitative in our approach, using our propriety systems and adopting advanced statistics and artificial intelligence to inform these qualitative views.

Our Diamond Ranking methodology and associated awards pulls from our extensive systems and aims to reward managers for outperforming on a historic basis. However, this is not a basis for determining whether a manager will outperform in the future. Our qualitative process aims to uncover the deeper story — who the manager is, how they think, and whether they can deliver outperformance going forward.

The reality is that highly rated managers do go through periods of underperformance. Understanding the sources of that underperformance and whether it is within expectations, is more important that the underperformance itself.

In a world where timing markets and cycles is difficult, we look to our robust process and our qualitative ratings to help us identify managers that we wish to partner with over the long-term.