Research carried out by Premier Asset Management’s Simon Evan-Cook suggested using sector averages creates a false impression of investors’ actual returns and, among other things, hands ammunition to those fighting the case for passives.
Under the current system, all the funds in a given sector are assigned an equal weighting when determining the performance of the average manager. In the IMA UK Equity Income sector, for example, the £7.8m UBS UK Equity Income Fund is ranked equally with Neil Woodford’s £12bn Invesco Perpetual High Income Fund.
However, Premier’s State of the Universe report argues for the use of weighted sector figures to show how the actual assets under management performed. Essentially, this would reveal the outcome experienced by the average investor in that sector.
The difference is important and leads to significant changes in how a sector’s performance appears. Although it would difficult to justify scrapping sector averages entirely, greater use of weighted figures could increase understanding of performance.
Sector averages ‘quite badly flawed’
Evan-Cook, a senior investment manager on Premier’s multi-asset funds, said: “The way the industry measures itself is quite badly flawed. The problem with how we do it at the moment, where everyone gets the same weighting, is that’s not how clients are invested.”
Returning to the IMA UK Equity Income sector, the manager pointed out that Woodford manages almost 40% of assets in this space across his three funds – which are bigger than 84 of the sector’s remaining 89 funds combined.
Despite this fact, the 84 smaller funds account for 91.6% of the sector’s average performance. “While the conventional sector average may represent the experience of the average UK equity income fund manager, it does not represent the experience of the average UK equity income fund holder,” Evan-Cook added.
When weighted performance is used, the IMA UK Equity Income sector underperformed the FTSE All-Share by 1.8% in the five years to the end of June 2012. This is much better than the 4.7% underperformance given by the conventional equal weighting approach.
In other sectors, the difference between equal and weighted figures is more dramatic. Take IMA Asia Pacific ex-Japan: the conventional method has the sector at a 7.8% underperformance against the FTSE World Asia Pacific Ex-Japan but Premier’s approach shows it outperformed the index by 2.6%.
“Most people in this sector beat the index because they were invested in good funds – the likes of Aberdeen, First State and Templeton – that had a great five years,” Evan-Cook explained.
In the majority of sectors, the performance experienced by the average investor is better than the conventional figures would suggest. But there are some exceptions.
IMA North America, for example, underperformed the FTSE USA index by 15.7% using the average fund approach but underperformed by 19.4% under Premier’s weighted method.
“[North America] always been the bête noire of fund managers and fund pickers but a 19.4% loss for the end investor is extraordinarily bad,” Evan-Cook said.
Changing how we view the universe
So what can we learn from Premier’s research? Evan-Cook said weighted averages could demonstrate the value of active management in the age-old active versus passive debate and offer investors a new way to analyse sectors.
The conventional method tends to underestimate returns, partly because it overstates the impact of funds’ fixed charges by magnifying the effect of the very small portfolios, whose performance takes more of a hit from these. It also reduces the influence of larger, more successful managers.
Rectifying this through weighted performance figures could counter the arguments of passive advocates, who often cite the understated sector averages when attempting to show the underperformance of active funds.
In addition, analysis of the data can throw up traits that show how fund managers have helped or failed investors, Evan-Cook claimed.
The manager has identified ten fund types that crop up in every sector, ranging from a ‘giant star’ (a fund that attracted large inflows on the back of great track record and continued to outperform despite its size) to ‘matter’ (small funds that “come and go”).
For Evan-Cook, finding a ‘protostar’, or a small to average-sized fund that is destined for greatness, is the goal of any fund picker. He believes his weighted sector analysis could be useful when finding these rising stars.
The arguments for greater use of weighted figures is compelling. Simple average performance can give a skewed view of the real outcome for those invested in the sector and fail to show, in most cases, where value was added.
But, as Evan-Cook stressed, the key to getting the most out of any sector is finding the best managers. While changing how a sector’s performance is viewed won’t offer a magic solution for fund selection, it could prove useful getting a picture of what’s really happening in that universe.