Investment Insider: Less risky funds can make good returns

Some money managers are very good at what they do. Some money managers are just plain unlucky. Some don’t try hard enough. And there are some who, to put it bluntly, are simply not up to scratch. To decide which category a fund manager belongs is not easy, especially if you do not have a long enough track record to judge their performance on.

Take Anthony Bolton as an example. Bolton made a name for himself when his Fidelity Special Situations Fund delivered a 20% annual return over a 25-year period. Over the same time span, the benchmark FTSE All-Share Index returned just 7.7%. Does that make Bolton an outstanding money manager? It does in my book. But we also must remember there were long periods when his fund underperformed the market. That could have prompted some investors to throw in the towel, which could have been a costly mistake over the long haul.

Neil Woodford is another money manager in the outstanding bracket. Over a 15 year period, Woodford’s Invesco income funds delivered returns of over 300%. The market only delivered about 40%. But we mustn’t ignore what happened during the huge market rebound in 2009 and 2010. Over those two years, the market jumped 30% and 15%, respectively. Meanwhile, Woodford’s funds improved around 10% a year.

The point is that investors and fund managers should not expect above average market returns year-in, year-out. That is unless they invest through an index tracker, in which case they will always get the market return. The Spot the Dog report by Bestinvest highlights the perils of stock picking. It has exposed funds that have underperformed for three consecutive years by more than 10%. It flagged up M&G as one of the worst underperformers with three funds in the spotlight. None of M&G’s funds underperformed in the previous report.

It is possible to scrutinise the ways that professional money managers look after other people’s money. A popular, though not fool-proof, method is to look at how much risk is taken by a fund to achieve its returns. Risk in this instance is measured by how volatile the returns have been in the past. So, a portfolio whose excess returns, over and above risk-free Gilts or Treasuries, that are less volatile can be viewed as being better than another whose returns are more risky.

The risk-adjusted measure of fund performance, developed by William Sharpe in the 1960s, helps us differentiate between different money managers. From an investor’s perspective, the higher the Sharpe ratio, the better should be the quality of the returns. That is because the excess return has been achieved by taking on proportionately less risk. A study was carried out on Warren Buffett’s Berkshire Hathaway investment portfolio to determine how he has managed to outperform the market by so much and for so long. It was found Buffett’s Sharpe ratio was almost double that of the overall stock market and better than the average for mutual funds over the last 30 years.

His outperformance came from investing in businesses with stable and predictable earnings; buying into companies with high margins and buying stocks that are cheap compared to their book value. In other words, it is not rocket science. It is also something we can do for ourselves.

David Kuo is director of fool.co.uk