Unit Trusts That Disappoint: Four Warning Signs

In December 2015 a local unit trust fund disappointed investors by losing 66% of its value in two days. There is no precedent in the local industry of such a large loss in a matter of days and it caught most by surprise. In a previous article, one of our portfolio managers, Chris Hamman, did warn that even fund managers obeying the guidelines provided by the Collective Investment Schemes Control Act (Cisca) could still lose a significant amount of money. Stricter risk management rules than that provided by Cisca therefore need to be enforced by managers.

But often advisers are not privy to all the details on how a fund is run. How do you then assess a fund’s true risk profile? Fortunately the regulator requires the fund’s fact sheet
(recently renamed ‘minimum disclosure document’ by the regulator) to be updated and made publicly available at least once a quarter. This inconspicuous one-pager may just prove to be the proverbial canary in the coal mine if you take the time to watch it closely.

As with any investigation, it’s necessary to work with a sufficiently large data set, and therefore the fact sheet analysis described below works better for funds that have been through a few years of market ups and downs, or at the very least through one bear and bull market cycle.

So, what are the warning signs to look out for?

1 The fund yields abnormally high returns

More than a century’s research, as published in Triumph of the Optimists, shows that equity markets – the top end of the risk spectrum – cannot be expected to beat inflation by much more than 7% p.a. over the long run and cash markets – the lower end of the risk spectrum – return barely 1% p.a. in real (after-inflation) terms. (Risk is defined as price volatility in this analysis.) A multi asset portfolio that diversifies across all asset classes can therefore reasonably be expected to return anything between 2% and 6% p.a. in real terms over the long run.

Years of exceptional equity market returns occur frequently (for example, 2009-2010 and 2012-2013), but then most equity funds will be performing well. Investors should, however, be wary of funds that beat inflation by, say, 17% p.a. over the long run during periods when their peers are not performing in nearly the same league. The old saying, ‘if it sounds too good to be true, it probably is,’ remains true when investing. The manager may be taking on undue risk to achieve those results.

2 The fund experiences above-average volatility

It’s important to compare the fluctuation of monthly returns with that of other funds in the same category. If the standard deviation on the fact sheet is more than double that of the average fund in its category, warning bells should go off.

3 The derivatives do not reduce the risk of the fund

Derivatives can be used to either reduce the risk in the fund, such as using futures to decrease the effective equity market exposure of the portfolio, or to increase (leverage) it. The latter is actually prohibited by the regulator’s board notice 90, but could still occur in practice. Therefore, whenever it is stated on the fact sheet that derivatives are used, it’s important to find out from the manager exactly how these instruments are applied. Good questions to ask the manager include: ‘What will happen when the market suddenly loses 5% in one day? And 10% in a week? What will happen to the portfolio when the market suddenly gains 10% in a week?’

4 It has a high TER without beating its peers

Funds with a total expense ratio (TER) of more than 3% need closer inspection. Is the fund delivering the kind of performance that will make up for these high costs? Is the benchmark at which performance fees kick in perhaps set too low – posing little challenge to the manager, but sending more performance fees to his pocket? Unreasonably high costs will eat away at returns over the long run, leading to disappointed investors.

While it’s not always possible to rely on a manager’s own description of a fund and its risk characteristics, to those willing to spend a little bit more time on a fund’s fact sheet and ask a few additional questions where anomalies are spotted a fund’s true nature will be revealed.