It’s a scientific fact that no two people are exactly alike. A few years ago, my family and I took a road trip through the Klein Karoo. Aside from being one of the most breathtakingly beautiful places on earth, it is also known for some of the world’s most beautiful mountain ranges. We spent the night in Prince Albert with Oudtshoorn as our next destination, and had the option of two possible routes to take us there. The first was the longer but faster route via Meiringspoort, and the other was the shorter, but somewhat slower route over the Swartberg Pass. Despite my wife’s fear of heights, our daughters convinced us to take on the Swartberg Pass. The amazing scenery and technical driving skills aside, I realised one thing: although we reached our destination safely, some found the journey thrilling, while others were extremely frightened by it.
These emotions not only apply to people who climb mountains or jump out of aeroplanes, but also to individuals who have to choose between different investment options. Let’s use two different equity fund managers as an example, both working for the same asset management company, but managing two different funds. For the one manager (Fund V in the graph below), it doesn’t matter how other shares perform. He has a specific strategy from which he does not deviate, and he believes that he is capable of getting investors to their investment destinations safely. For the second fund manager (Fund E), it is important to remain within the confines of something like the FTSE/JSE All Share Index and he correlates his returns much closer to the returns delivered by the index itself. Both of these funds (E and V in the graph below) are Equity Unit Trust funds, both have a fund value of
R4 billion or more, and more importantly, both managed to outperform the FTSE/JSE All Share Index on a total proceeds basis (after all costs) over the past 10 years, an achievement very few funds with a 10-year history in this sector, can brag about.
Probably the biggest difference between these two funds is the fact that Fund V didn’t only underperform against the index at times, but that it delivered extremely negative returns during times when the index performed positively. Does that make Fund V the wrong choice or a bad fund compared to Fund E? Not at all. Clearly both fund managers are more than capable of doing their jobs, it just means that as in the case of the Swartberg Pass and my wife’s fear of heights, some can handle the stress of volatility and some cannot.
The important question is, how can you prepare yourself for the accompanying stress to the best of your abilities before making an investment? How should you choose between the more daring route over the “Swartberg Pass” or the more level and “safer” route, especially when you find both of these funds’ returns attractive? For me, the answer lies in the tracking error. The financial term for this ratio is defined as “the divergence between the price behaviour of a position or a portfolio and the price behaviour of a benchmark” (source: Investopedia).
The tracking error is usually expressed as a percentage. The higher the tracking error, based on historical data, the higher the possible deviation may be compared to the relevant benchmark.
Again, using Local General Equity Unit Trusts as an example, with their current three-year average tracking error of 5.9%, it means that these funds can either outperform or underperform against the FTSE/JSE All Share Index by 5.9% over any rolling 12-month period.
If you are not comfortable with large underperformances against the FTSE/JSE All Share Index, rather choose funds with a ratio of 5% or lower by conducting proper quantitative and qualitative research. For those who invest in the management of the company and who do not particularly mind the returns delivered by the index, a tracking error of nearly 19%, as in the case of Fund V, won’t matter at all.
It may be that investors all want to reach the same destination in the end, but it remains of the utmost importance that you choose the route that suits you best to get there, so you can be prepared for the journey.
The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. These opinions do not constitute advice. This is intended as general information and does not form part of any financial, tax, legal or investment related advice. Although the utmost care has been taken in the research and preparation of this blog, no responsibility can be taken for actions taken based on the information contained in this blog. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.