Eight years of market outperformance seen as indicator of skill …
An article in “The Australian” of 20 October 2010, titled “Ace stock picker John Sevior the key to bid for Perpetual”, suggests that the proposal by private equity group KKR to purchase fund manager, Perpetual Limited, depends on retaining the services of veteran stock picker, John Sevior.
To illustrate Sevior’s importance to the Perpetual business, the article points out that since he was appointed head of Australian equities in September 2002, Perpetual’s flagship Wholesale Australian Share Fund had returned 12% a year (net of fees). This compares with the annual return for the well accepted market benchmark, the S&P/ASX 200 Accumulation Index, of 10.22% for the same period.
The article goes on to say:
“Industry observers said yesterday a 1.78 per cent outperformance a year for eight years was a creditable effort. This was especially so because the market was driven by growth stocks (the commodities boom) for much of that time, while Perpetual is a so-called value manager specialising in finding undervalued companies”.
So the conclusion appears to be that Sevior (and his team) must be highly skilled and adding significant value. But is this a valid conclusion?
The “market” may not be the appropriate benchmark
As the article points out, Perpetual is a “value manager”. It is therefore inappropriate to compare its performance with the overall share market, that comprises both value and growth shares. It is like comparing “apples with oranges”.
The research of Professors Eugene Fama and Ken French reveals that over extended periods, value shares have outperformed and can be expected to continue to outperform growth shares. Fama and French claim that the additional return is compensation for additional risk.
As considered by Fama/French, value shares are those that are relatively low priced, measured by metrics such as dividend yield, book to market and price to earnings ratios. They are “out of favour” shares that need to provide a higher expected return (via reduced prices relative to growth shares) to attract buyers.
On the other hand, growth shares are “market darlings” – well known, well managed companies, perhaps in “hot” sectors of the market. They are seen as relatively low risk by investors and are demanded despite offering lower expected returns. For a more detailed explanation of value and growth shares, see “Risk and return are related”.
Unlike Perpetual and other active value fund managers, Fama and French don’t consider value shares are mispriced or “undervalued”. They believe the market does a pretty good job pricing all shares and it is very hard to reliably beat its assessment. The historical and expected future outperformance of value shares is compensation for the increased risk associated with buying “market dogs”, given that many of them will eventually have to be put down.
So, if the Perpetual Wholesale Australian Share Fund is, primarily, a value fund, perhaps it is more appropriate to compare its performance with a value share benchmark, as defined by Fama and French. Perhaps, the fund’s apparent outperformance is not due to skill (or luck), but simply the fact that value shares behave differently than the total market.
The performance of the Dimensional Australian Value fund potentially offers a better comparison. This fund faithfully applies the findings of Fama/French to investment practice. It buys all shares that meet Fama/French’s value criteria (essentially the top 30% of all shares, as measured by book/market ratio) by their approximate market weight. There is no attempt to pick the “best” value shares.
How did the Dimensional Australian Value Fund do over the eight years to September 2010, with its passive, rather mechanical, approach to selecting value shares? It returned 12.67% p.a. i.e. 0.67% p.a. more than the Perpetual fund!
So it appears the Perpetual performance that is being attributed to “ace stock picking” is most likely largely due to a value bias, with its inherent higher risk. As Dimensional’s results prove, this value benefit could have been captured more purely and with higher returns without any stock picking at all. Perhaps, Perpetual’s stock selection attempts actually detracted from its performance!
The cult of the fund manager “super star”
The purpose of this Blog is not to suggest that John Sevior is not a skilled fund manager. He may be. Rather, it is to provide a typical example of the media’s either unwitting or deliberate efforts to have us believe that there are “rainmakers” in funds management, they can be identified and that their apparent past success will continue in the future.
This is despite the fact that the most rigorous academic research provides little support for the notion of fund manager super stars. Once past performance is corrected for style biases (i.e. value versus growth, small versus large shares), very few active fund managers outperform appropriate passive benchmarks. And even for those who do, the numbers are less than you would expect by pure chance suggesting that luck may be more a factor than skill.
As an investor, if you choose to ignore the academic evidence and are attracted to the superstar concept you then need to know what you will do if your superstar is hit by the proverbial truck. This “key individual risk” is substantial.
The notion of paying billions of dollars for a firm provided the services of an “ace stock picker” are retained may make for a good newspaper story. However, as a hard headed business proposition, it makes no sense at all to us.