How do you identify the best superannuation fund or managed fund? It would seem logical to compare the net investment returns (after fees) over various periods of time and select the one that has produced the best results. But you would be wrong. This approach will not necessarily identify the funds that will produce the best returns in the future. I will use this blog to outline a more successful approach.
You must realise that most investors are late to the party
If a managed fund or super fund has a few good years, investors tend to flock to those funds – in the hope that the good investment performance will persist and they can enjoy high returns. However, research shows that most investors are too late – they invest in the fund towards the end of a “good run” and end up generating ordinary returns.
For example, a research report published last year compared the investment returns generated by all managed funds in the US between 1991 and 2013. They compared the published time-weighted returns with the actual dollar-weighted returns that the investments produced. For exmaple, Fund X might have a time-weighted return of 20% p.a. for the 2016 calender year – which, for example, might be made up of 15% in the first half of 2016 and only 5% in the second half. If most people invested mid-way through 2016 (after they produced outstanding returns), they would have only earned a small return of 5% – this is the dollar-weighted return.
Chasing returns: likely to cost you 2% p.a.
The dollar-weighted returns (in the research mentioned above – see chart below – click to enlarge) were about 2% p.a. lower than the time-weighted returns. This is because most people invested monies after the ‘good performance’ had already occurred – this is called ‘performance chasing’. Vanguard arrived at very similar findings in its research too. By the way, note that the index beat most of the managed funds!
In conclusion, we know that selecting managed funds and super funds based on past performance isn’t the right approach.
Can’t beat the market in the long run
These findings reinforce our belief that actively managed funds cannot beat the market on a consistent basis (for more, refer under subheading “And if you are “lucky” enough to pick a winner, it won’t be for very long” in this blog). Therefore, the strategy that has the highest probability of maximising your returns is to invest in low-cost, index funds (as discussed in the aforementioned blog).
No one knows which asset class will do well
No one in the world has developed a reliable and repeatable methodology for predicting which asset class will perform the best in the short to medium term. Vanguard posted the chart below (click to enlarge) on LinkedIn which sets out how much a $10,000 investment made in 1987 would be worth today. You might be surprised to see that Australian bonds come in 2nd. That’s not to say we should invest in bonds – but more importantly it’s wise to adopt a long-term asset allocation based on the fundamental assumption that no one knows which asset class will work and when.
And the winning approach is…
So far, we know that comparing (chasing) returns isn’t the right approach – nor is trying to pick the next “winning” asset class. Instead of these approaches, I recommend the below 3-step approach will produce the best results:
1. Pick your methodology – you either believe that passive investing will produce superior returns (compared to active investing) in the long run, or you do not – there isn’t really any middle ground. If you believe in passive investing, then you must select an investment/super fund manager that invests passively. Also, this means you no longer need to worry about whether you have picked the “right” fund manager or super fund – because you know that you will always get the market return – and beat the vast majority of active managers in the long run. Comparing your returns against other (actively managed) funds is meaningless – as research demonstrates that long term results matter the most. From year to year you will always find a handful of funds that will beat the market (index) – but picking these in advance is like finding a needle in the haystack – instead, invest in the haystack (i.e. index).
2. Pick your desired asset allocation – once you have decided to adopt a passive methodology, the next thing to choose is which asset classes you want to invest in. Maybe it’s a small investment for your kids and you only want to invest in the Aussie market. Or, if it’s your super, then it is almost certainly better to have a diversified asset allocation.
3. Identify the lowest-cost way of implementing above (steps 1 & 2) – the final step is to identify the lowest-cost avenue to implementing your desired asset class exposures. For example, if it’s a small investment in one or two asset classes, the lowest-cost avenue is probably to set up an online trading account and invest in ETF’s. If it’s your super, then setting up a wrap/platform account will give you full control, a huge investment menu and allow you to minimise investment fees.
Need help? Or a second opinion?
Investing in index funds is a relatively simple strategy. However, not all index funds are created equal – so you must be very careful to understand what you are investing in, how it is managed and the risks involved. Keep away from synthetic ETF’s for example. It is wise to seek independent advice – even if it’s just a second opinion – to ensure you are on the right track.
ProSolution Wealth Advisory specialises in designing and maintaining low-cost, passive investment portfolios using evidenced-based strategies on behalf of its clients on a pure (fixed) fee-for-service basis – not commissions or percentage-based fees.
