The buy-and-hold investment philosophy, upon which Warren Buffet built his fortunes, maintains that the key to successful investing is to identify a good, quality company, buy it at a reasonable price and then hold it over time irrespective of short-term market returns.

The counter-argument to this is tactical asset allocation. This is where investors aim to buy when the market is cheap and sell when it is high. The problem is that for most investors, this “market timing” often results in more losses than gains.

A study carried out by financial services company Acsis found that on average, investor returns are less than the after-costs return of the fund they are invested in. Over the period of the study, Acsis found that the average fund in South Africa delivered an annual return of 9.4%, while the average investor only received 4.1%. The reason is that investors continually attempt to time the market. When the market falls and losses have occurred, investors get nervous and cash in their money. Then the market recovers and once everyone is feeling more comfortable they re-invest their money, usually at a higher price than they sold it for.

While DIY market timing may not work, another option is to invest in a fund where an experienced fund manager is making those market timing decisions, hopefully with more information and less emotion.

Flexible funds fall under the multi-asset class of collective investment schemes (unit trusts) and fund managers are allowed to invest in any asset class depending on their view of the market. Unlike an equity fund which has to hold at least 80% in equities at all times, a flexible fund manager can theoretically hold zero equities if they so choose.

Francis Marais, Research and Investment Analyst at Glacier by Sanlam, compared top-performing equity funds with equivalent flexible funds, and found that flexible funds outperformed their general equity peers over time.

Flexible funds tend to have high expense ratios as they include performance fees. Last year the average annual management fee for the sector was 1.31% but the average net expenses were 2.26%. Some funds have total expenses in excess of 4% per annum.

Interestingly, Marais found that on average, the flexible funds had less exposure to equities yet had performed better. Considering that over time equities outperform cash, why would flexible funds outperform?

The problem with pure equity funds is that, given the mandate, even if a fund manager is seeing little value in the market or struggling to find shares they would like to invest in, they are still forced to hold equities, even if they believe they are overpaying for the asset.

In contrast, a flexible fund manager can sit in cash or bonds if they cannot find companies they want to invest in. That means when the market corrects or share prices fall, creating value opportunities, flexible fund managers have an opportunity to buy into those shares. Marais found that during market corrections, flexible funds outperformed equity funds, adding to their overall outperformance.

Not all flexible funds are equal

While Marais makes a good argument for flexible funds, his research only focuses on some of the better-performing funds which make up part of Glacier by Sanlam’s “shopping list” which is made available to their financial advisers to assist them in selecting funds for their clients.

These include asset managers PSG, Bateleur, Laurium and Truffle. Yet, when you look at the entire universe of 67 South African flexible funds, the returns are very divergent. The following are based on returns up to 31 December 2015:

• Over a six-month period, the top-performing fund delivered a 15% return while the third-worst-performing fund delivered a negative 8%*. The median return for the category was 1.82%.
• Over a one-year period, the best-performing fund delivered 23% compared to a negative 6.25% from the third-bottom fund*. The median return was 6.34%.
• Over a five-year period, the best fund delivered 20% per annum while the worst fund delivered a negative 1.53% with a group median return of 9.66%. That means over five years, the best-performing fund has delivered a total return of nearly 170%, whereas the worst-performing fund delivered a loss of 8%.

(*The Third Circle fund returns were left out of the above examples as they are an anomaly).

So selecting the correct fund is extremely important, and part of that selection is understanding how the underlying portfolio is managed and the risks that are being taken by the fund manager, as flexible funds do not share the same risk profiles.

A great example is asset management company Third Circle whose Targeted Return fund wiped out 66% of their clients’ money in two days in December 2015 when the market fell on the news of the firing of Finance Minister Nhlanhla Nene.

After an investigation by the management company, Met CI CEO Mickey Gambale concluded that “the fund strategy employed by the portfolio manager was unable to cope with the extreme market events at the time and as a result the fund suffered losses due to the market movements. The use of derivative instruments and hedging techniques employed by the manager were unable to deploy and behave as the portfolio manager had expected, therefore resulting in the significant deviations noted”.

Understand where performance is coming from

Basically, Third Circle were using a high-risk strategy where big losses could be incurred. The lesson to be taken from this is that when selecting a flexible fund, do not just look at the returns. Make sure you understand the risk profile of the fund you are investing in by reading the fact sheets. Some funds will talk about a balance between growth and protecting investor capital, placing their funds in the moderate-risk category, whilst others will stipulate that they are targeting high growth and a higher-risk strategy.

Adri Messerschmidt, senior policy adviser at the Association of Savings and Investments South Africa (ASISA) says when it comes to flexible funds, you should ideally be getting advice from a financial adviser who has knowledge of the fund and is able to make an informed decision based on your required risk and return profile.

Messerschmidt says there are many layers of protection for a client to ensure that a fund is managed within its portfolio mandate. The fund manager has to provide information to their compliance officer, a compliance officer at the product provider/management company, as well as the trustees of the fund. The Financial Services Board also requires regular information to ensure that the fund is meeting regulations.

Flexible funds can however take fairly aggressive positions and although fund managers are required to provide minimum disclosure documents, which includes producing a fact sheet with their performance and portfolio holdings every quarter, a lot can happen in three months.

The fact that Third Circle described its Targeted Return fund as a moderate- to high-risk fund offering “stable positive returns” suggests that fund managers don’t always stick to their original mandates. So it helps to invest through large financial advisory houses like Glacier by Sanlam who have the buying power to demand more disclosure than the average retail client has access to.

At the moment Marais says some funds are showing strong short-term outperformance, but when you drill down to their underlying portfolios, they have taken significant bets on resources. They are fully invested in the market with high exposures to single stocks such as Anglo American which doubled in value between March and April this year. One could argue that there is a skill in identifying a strong rally in a sector, but the counter argument is that these types of positions carry significant risks of which the investor may not be aware.

When past performance hides real performance

The other problem is that short-term luck can also skew long-term performance statistics. If a fund manager takes a really big bet on a sector and outperforms their peers by 15% over six months, even if the performance falls sharply after that, going forward their annualised returns would look impressive. For example, if in one calendar year the fund delivered 15% in February but the total return from the rest of the year was just 10%, then its annual figure would show 25%. The following year the fund only averaged a total of 10% for the year, but the two-year figure would show an annualized return of 16%. This hides the lack of consistency in its return profile.

Marais says one should rather look at returns over a period of time on a monthly basis. So for instance, what was the one-year return figure at the end of January 2015, then the one-year return at 29 February 2015, then the one-year return at 31 March etc. “This is then plotted and one can clearly see how consistent these one-year figures are. The same applies to three-year and five-year figures. This tends to smooth the returns, with the effect of big monthly returns a lot more muted.”

This article first appeared in City Press.