Do DFM Performance Numbers Pass the Ronseal Test?

Since the phrase “It does exactly what it says on the tin” was first used in 1994 by Ronseal in their television advertisements, it has entered English idiom and become widely used to describe anything that is exactly as it appears or claims to be without any need for further explanation or qualification. Such things might be said to “pass the Ronseal test”.

This article examines the question of whether discretionary fund manager (“DFM”) performance numbers, as quoted in marketing literature, generally pass the Ronseal Test.

What Type Of Performance Data Is Being Presented?

Whilst a small minority of DFMs make it a point of principle not to present performance numbers to potential clients, the majority of DFMs accept the need to present historic performance figures as part of their investment management credentials. Such numbers fall into four broad categories and it is important that potential clients and their advisers are aware of the providence of the numbers being presented. The four broad categories are:

1. Simulations

2. Model portfolios

3. Funds; and

4. Composites of actual portfolios

Simulations

For newly established DFMs and those with short track records, the only type of performance data available is likely to be simulations based on either the indices or on the investments that the DFM believes would have been held if they had been running money at that time. Whilst simulations can be helpful, such results clearly need to be taken with a hefty pinch of salt as they are constructed after the fact, with the benefit of hindsight. Simulations tend to be more interesting for what they reveal about investment philosophy and process than for the performance numbers themselves.

Model Portfolios

Models take many forms and it is crucial to understand how model performance data has been constructed. A model may be constructed with the benefit of hindsight or may be run “real time”. It may or may not take account of trading costs, liquidity constraints and implementation slippage. At their best, models are run as if they are “real” portfolios and thereby provide an accurate insight into the returns that a client would have received. However, often models are little better than simulations.

Funds

For those DFMs who run a pooled investment vehicle with the same mandate as is being offered to private clients and/or charities on a discretionary basis, such funds provide a very accurate reflection of the performance that a discretionary client might have experienced. For publically traded funds, the performance data must be independently audited and quoted after investment management fees and trading costs have been deducted. Being a true and fair record of performance history, funds are very helpful in setting out how a DFM has done for a given mandate. However, most DFMs would argue that funds have more rigid investment mandates than discretionary portfolios, the latter allowing more active risk management.

Composites of Actual Portfolios

The best type of performance data for a potential investor to analyse is undoubtedly a composite based on a basket of actual portfolios. This type of data presents actual outcomes experienced by investors with similar mandates to that being proposed by the DFM. Most DFMs construct discretionary portfolios using common building blocks and investment disciplines. Yet outcomes will inevitably not be the same for two clients even if they have identical mandates. Differences will occur for many reasons including portfolio establishment speed; timing of deposits into and withdrawals from the portfolio; fee arrangements; client feedback; tax considerations and size of portfolio. However, by using a basket of portfolios following similar mandates, an average performance can be calculated that accurately portrays the typical performance of a DFM for a given mandate.

The usefulness of a composite for understanding a DFM’s capabilities is determined by the number of portfolios in the basket (i.e. what proportion of the total client base is included) and the level of return dispersion between portfolios which comprise that composite (i.e. the range of returns experienced by contributing portfolios). These metrics should always be considered alongside the performance of the composite.

Measuring Intra-DFM Return Dispersion

ARC calculates composites based on around 50,000 underlying portfolios for over 50 DFM’s each month as part of the PCI calculation process. One of the charts included in the ARC PCI Report each quarter sets out data for the 25th and 75th percentile DFM in each ARC PCI index category over various time periods. The table below is an extract from the March 2014 PCI Report and highlights the return dispersion between DFMs:

The table reveals that, over the last 12 months, the return differential between DFMs running “Steady Growth” mandates has been just over 2 percentage points (25th percentile DFM up 5.6%; 75th percentile DFM up 3.5%).

However, what about the return dispersion within a single DFM? Analysis of the 53 DFMs within the ARC PCI Universe over the 12 months ended March 2014 reveals the following:

• The average return dispersion for portfolios managed by a single DFM is around 200 basis points over the last 12 months.
• Half the DFMs had dispersion levels between 150 and 250 basis points.
• The greatest dispersion of returns was 400 basis points.

Measuring the degree of variation experienced by clients within the same DFM allows us to conclude that for around a quarter of discretionary clients with a top quartile DFM, the positive impact of selecting a top quartile DFM was negated by being one of the poorer performing portfolios managed by that top performing DFM.

The chart below provides the supporting data by plotting the internal dispersion for all those DFMs with a significant number of portfolios included within the ARC Sterling Steady Growth PCI calculation for the 12 months ended March 2014.

What Should Be The Response of Investors?

Our analysis suggests that performance metrics presented by DFMs need to be put into context. All prospective investors should consider the following:

• When analysing performance numbers presented by a prospective DFM, the type of numbers being presented should be clearly understood – well constructed composites provide the most accurate guide;
• Selecting a consistently top performing DFM should have a material impact on performance – for example, based on a “Steady Growth” mandate, over the last 12 months the 25th percentile DFM has outperformed the 75th percentile DFM by around 200 basis points; and
• Once a DFM is appointed, the way in which the chosen mandate is implemented can have a material impact on the outcome relative to other clients with the same mandate. In extreme circumstances, this impact can be sufficiently negative to undo all the hard work of identifying a top performing manager.

The attraction of investing in a discretionary portfolio rather than a fund is that the DFM can tailor the portfolio to take account of a client’s evolving circumstances. That means DFM performance numbers can only ever be proxies of actual outcomes for individual investors. It is therefore vital that prospective investors understand the providence of any performance numbers presented by a DFM.

However, only if well constructed composite performance is presented can an investor be confident that the DFM is meeting the Ronseal Test.