Many diversified funds appear similar on the surface, but when you lift the hood, they’re poles apart. Evaluating diversified fund performance can be like comparing the proverbial ‘apples’ with ‘oranges’.
 
But in this complex and volatile investment environment, choosing the right diversified fund has never been more important for investors and advisors. The wrong fund will not only be too risky, but its performance could mean failing to reach important financial goals. 
 
Advisers and investors need a system to evaluate performance across diversified funds that is simple, consistent, and allows them to compare ‘oranges’ with ‘oranges’. The process particularly needs to consider not just return, but also risk. 
 
We have identified 4 simple steps for effective evaluation of diversified fund performance. If advisers and investors follow these, they’ll increase the probability of choosing the right funds and reaching financial goals.

1. Pick a peer group 

The first step is to select a representative universe of funds for consideration. For example, you might choose a group of the largest diversified funds in Australia. Obviously, in a broad sense, the funds should correlate with a financial goal, such as income, or growth.

2. Measure risk 

Once you have a peer group, it is tempting to focus solely on performance when evaluating diversified funds. But performance is just one side of the coin: risk is the other. If Fund A delivers a higher return than Fund B is it a better fund? Not necessarily. An investigation of Fund A might reveal the manager took bold risks to achieve those higher returns. 
 
A simple comparison of fund returns, therefore, is not enough. There are four metrics that allow advisers and investors to determine how risky a fund is, which will help put performance numbers in context.
 
a) Growth asset exposure
 
Consider each fund’s allocations to growth assets. Growth assets, such as shares, property, infrastructure and growth alternatives (commodities, private equities and hedge funds) have high expected returns over time, but also higher volatility. Therefore, funds with higher allocations to growth assets are considered riskier than those with lower allocations. 
 
The most common method of quantifying a diversified fund’s risk level is identifying what proportion is invested in growth assets. 
 
b) Volatility
 
Next, consider the fund’s variability – or volatility -- of returns during its history. Riskier funds tend to be more volatile – their value fluctuates more widely; lower risk funds tend to have more stable returns.
 
It is important to remember that volatility doesn’t measure how likely an investment is to permanently lose money, which is many investor’s understanding of what risk is. Yes, volatility and risk of permanent loss are correlated, but at times they can be very different things.
 
c) Scenario analysis
 
Thirdly, perform a scenario analysis. This analysis is also known as ‘stress testing’ because it measures portfolio performance during historical situations and simulated hypothetical events.
 
An easy scenario analysis is to see how different funds performed when markets fell historically. A ‘drawdown’ graph shows how much funds lost in market crises, which gives a good idea of a diversified fund’s risk profile. Fund A might have been more resilient than Fund B during the global financial crisis (GFC), an indication it is probably less risky than Fund B.
 
d) Illiquid assets
 
Finally, when assessing the riskiness of a diversified fund, consider its allocation to illiquid assets, such as unlisted property, unlisted infrastructure and private equity. They are a hidden risk factor in many diversified funds.
 
Illiquid assets are typically assets not traded on a centralised stock exchange and can’t be bought and sold easily. Investors might not be able to redeem (get their money back) for a long time, at times years. Sometimes, assets may need to be sold at big discounts to their true value.
 
Investors often ignore the risks posted by illiquid assets. But even moderate (around 20 per cent) allocations to illiquid assets can pose substantially increased risks to diversified fund investors. Those risks aren’t captured in standard risk measures. It’s advisable to separate out these funds with moderate and high allocations to illiquid assets in any risk/performance evaluation.

3. Consider tax and fees 

Once you have a group with similar risk exposures, you then need to consider the effect of tax and fees. To have a fair comparison, all returns must have the same fee and tax basis. 
 
Some funds report ‘before’ or ‘after’ fees, and ‘before’ or ‘after’ taxes. Superannuation can complicate the picture. Funds that only have super investors base their performance numbers on the lower concessional superannuation tax rates; other funds with a diverse investor base report performance numbers using higher non-superannuation tax rates. 
 
Ultimately, the tax rate you pay depends if you’re inside or outside super; it’s not whether the fund is a super fund or not. It’s important to be mindful that, for those investing within super, post-tax super fund returns are likely to appear slightly inflated relative to other diversified funds.

4. Tally over time 

The next step is to take a long-term view of performance. When comparing funds with similar risk exposures, it’s tempting to evaluate each fund using a snapshot of a fund at a single point in time. But that fails to capture how funds perform over time. It’s like trying to judge how good a footballer is by looking at a photograph. 
 
Performance and risk, instead, should be compared on a chart which shows how the fund performed over time.
 
Diversified funds are managed as long-term savings vehicles and should be judged on that basis. Performance over one-month and three-month time horizons is typically irrelevant because managers aren’t making decisions with such short payoff periods in mind. Investors should focus on performance over periods of at least five years.

An additional comment: past performance is not an indicator of future performance

By following the four simple steps above, when evaluating diversified funds, advisers and investors will be able to compare ‘oranges’ with ‘oranges’. 
 
However, it’s important to emphasise (given that this article has solely focused on judging past performance) that: past performance is not a reliable indicator of future performance. Any historical performance analysis needs to be overlaid with two questions which focus on the future:
 
1. Why has the fund outperformed/underperformed? 
 
2. Are the drivers of the outperformance/underperformance sustainable and likely to be repeatable into the future?
 
Without answers to these questions evaluating historical performance is not only pointless; it can be dangerously misleading and shouldn’t be relied on for decision-making.

 
About the author
Stephen Flegg, Portfolio Manager at AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person without the express written consent of AMP Capital. © 2017 AMP Capital Investors Limited.