The performance chart, with its ability to average out bad years with good, does have its appeals, admits Alistair Blair. But it's wiser to judge each year on its own merit.
God bless marketing men everywhere. And their little devices. Just about every unit trust sales pack includes a chart showing performance on the vertical axis and time, usually the last five years, on the horizontal axis. Two lines snake across the chart: one for the trust in question, and one for the index against which the fund manager measures his or her trust. Almost invariably, the trust appears to come out a winner, by being ahead of the index at the right hand side of the chart. They are very compelling, those little charts. You can see why the marketing men love them, but they can be very misleading.
Winning the investment race is about doing better than the index on a regular basis. Lumping several years together, as those little charts invite you to do, obfuscates the issue of how the trust has performed in discrete years. This point is easily demonstrated. Bloggins sets up a unit trust which has a highly successful first two years. After selling the initial units at £1, the trust's price rises to £1.80. The market as a whole is only up 40%. Everyone is very impressed and the money floods in. But years three to five are a different story. The shares that did so well start to underperform. They're sold, and the replacements aren't much better. By the end of year five, the Bloggins trust stands at £1.75.
Meanwhile, the market is up 60% over the five years.
So who did best? Bloggins's little chart shows it did: there's its blue line comfortably ahead of the yellow one, which shows the progress of the index. And in a way, it did: but not in the way that would matter to most investors. It's true that Bloggins beat the index over five years, but that's simply the average of two good years and three bad ones. The investors who bought into Bloggins in year three don't think it did very well: they're down. Their chums, who bought tracker funds which deliver the same performance as the index (well, they don't, but that's another story) are content. In effect, they bought at £1.40 and they're now sitting on £1.60.
Next time you're inspecting one of those little charts, check that the gap between the unit trust line and the index line gets increasingly wide over the years. Only then can you be sure of a consistently superior investment performance.
It is useful to know how a unit trust or any other investment has performed since it started, since the individual fund manager took over, or over any long-term period. But it's nowhere near as useful as knowing how it did in each individual year. The problem with the line chart is that it invites your eye to inspect the cumulative performance of the fund, but as the Bloggins example shows, that means one or two good years of performance may in effect be carried over and averaged into subsequent flat years.
Of course, it would be as easy as ABC for unit trust companies to give you performance figures for discrete years. The accepted method is to divide the complete span of investment performances each year by all the trusts within a sector - UK Growth, for example - into 10 deciles (or four quartiles). With deciles, the funds will be assigned, according to performance to the top 10%, the next 10% down, and so on, to the bottom 10%. Quartiles work exactly the same way, except, as the name suggests, they use the top 25% and so on. With such a system, investors need only to check that their trust more often falls into a higher decile than a lower one.
In the accompanying chart, we translate this 'which decile?' approach into an easily understandable 'marks out of 10' approach, where a top decile performance gets 10 marks and a bottom decile performance gets one mark.
For most purposes, in fact, rankings by quartile rather than decile are probably preferable. Individual trusts are bound to bob around between deciles: tracking them with this degree of precision imbues performance assessment with an unlikely degree of accuracy. Think of it this way.
It's skill which will determine which quartile an investment manager falls into, and it's luck which will determine whether he or she is top or bottom of that quartile. What you want to focus on is the skill, not the luck.
If you can find a fund which is consistently in the second quartile, you're probably looking at what will be a long-term winner, even if it never gets into the top decile in any individual year.
Even when independent commentators get down to measuring investment performance, the focus is too often on performance to date rather than discrete performances year by year. The Saturday money pages regularly analyse which are the top five or 10 performers over three and five years. But this treatment contains the same cumulative flaw as the unit trust companies' own marketing charts. It can portray as a top performer a trust which has had one or two outstandingly good years alongside several mediocre ones. For example, at present, the Standard Life UK Equity Growth unit trust appears in many analyses as one of the top five UK Growth unit trusts. That's some accolade given that there are around 160 funds in the sector. But perhaps its current position has something to do with its 1996 performance when it was in the top 5% of all UK Growth unit trusts. In none of the other four years for which information is available did it make the top 40%. The trust's record is good enough, but not as good as a top five ranking makes it sound.
Two other aspects of the investment performance should be borne in mind by investors. In neither aspect do fund management companies invite publicity.
First, managers move on. This may not be too significant if the fund management company has a very collegiate style - Schroders is a firm which comes to mind - but in other cases the performance of a fund may be very much down to a single individual. This observation does not amount to advice to sell a high-flying fund if its manager moves on, as the management company will be at least as concerned as its investors to replace talent with talent. But if the attractive historical performance of a unit trust encourages you to put some money into it, you might just consider checking that said performance was not clocked up by a fund manager who has recently moved to fresh pastures.
The second aspect, implicit throughout the foregoing, is known as volatility.
Everybody who invests in the stock market, whether directly or via a unit or investment trust, appreciates that what goes up can come - nay, comes - down. If you've had a good month or a good three months, you can be sure that a down month is on its way. This is why, over the long term, equities earn more than building society deposits, which of course, never go down: in return for accepting that equities may go down in the short term, investors are only prepared to pay such prices for those which ensure that over the long term they appreciate at a faster rate than safer bank and building society deposits. This is known as the equity risk premium.
All equity funds, including unit trusts, bounce around. But clearly the volatile bounce around more than others. Fund managers with a predilection for small company shares, recovery situations or growth companies tend to experience more volatility than those who invest broadly across the whole market. In return for this volatility, they expect to gain higher growth over the long term. They may indeed deliver this and thereby put together what looks like an especially attractive record. But investors ought to appreciate that they are paying for the higher growth by accepting an increased likelihood of being down in the short term. If unit trusts A and B have identical performance figures but A is a lot more volatile, it's B which is to be preferred.
So where is the investor to obtain all this information which will allow a proper view of performance? Clearly not in unit trust marketing literature and still less in unit trusts' annual reports to investors, which are often woefully short of relevant information. At least one £1-billion unit trust annual report highlights its performance as compared with that of a building society deposit - a scandalously misleading comparison, carefully selected.
Summarised figures from the independent measurement firms, Micropal and HSW, are available in trade magazines such as Money Management, Planned Savings and Moneyfacts, but the most painstaking, all-round review of performance is probably that published by Standard & Poor's Fund Research.
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There are figures, and there are figures
Looks good enough? This chart is taken from the sales literature of a top fund management group. It has certainly been good enough to pull in £200 million of investors' money (including £80 million in the last year).
That makes it the second biggest unit trust in a sector of 40. Yet a rating of the fund's performance against competitors', by an independent performance measurement firm translates into the following marks out of ten. Marks out of 10: 1994 - 4;1995 - 4; 1996 - 5; 1997 - 1. Its volatility was nothing to write home about either.