If the markets take a dip, how will your unit trusts bear up?

You should look not only for investments that perform well over the long term but also for those that can weather bear markets well, PlexCrown Fund Ratings suggests in its latest research into the worst losses recorded by South African unit trust funds over the period since December 2000.

This view is especially relevant now as equity markets reel on news of poor prospects for global economic growth, the downgrading of the United States credit rating and high levels of government debt, particularly in Europe.

Many fund managers remain positive about investment prospects over the long term, but Ryk de Klerk, the executive director of PlexCrown Fund Ratings, says another bear market cannot be excluded.

Although you may be investing over the long term for your retirement and expect to sit out any shorter-term bear market, you can never be sure when you may need to access your investments, De Klerk says.

Losing your job, disability, illness or premature death could result in your (or your dependants) having to access your investments before you had planned to do so. For this reason you should look for investments that show the smallest losses at any point in time.

De Klerk determined the worst losses that South African unit trust funds have made over rolling 12-month periods from December 2000 to July this year (that is, he considered the 12-month return for each month of the year over the 10-and-a-half years – some 126 periods) and found that some funds have fared a lot worse than others. These losses are known in the industry as downside risk.

He also found there were huge variations in the losses (or small positive returns) recorded by funds in the same unit trust sub-category during periods when markets were at their worst.

Choosing a fund that is a good performer, although not necessarily the best performer, and that, relative to its peers, has a lower risk of incurring losses, can protect you from potential bear markets, he says.

The worst losses funds recorded over any 12-month period since December 2000 are, as can be expected, in the year between June 2008 and July 2009, De Klerk says. (Performance was measured with income reinvested.)

Among the domestic unit trust sub-categories, real estate funds showed their worst 12-month losses in June 2008, prudential medium equity and prudential high equity funds in October 2008, and industrial funds and small cap funds in November 2008. Equity general funds (including growth and value funds), large cap funds, financial funds and flexible funds had their worst 12-month losses only in February 2009.

In the period from June 2008 to July 2009, one smaller-companies fund recorded a year-on-year loss of 65 percent.

When the worst 12-month returns of all the funds in a sub-category are averaged, it is clear that funds used by pension funds or offered to retirement annuity investors in the asset allocation prudential sub-categories were not spared large losses.

In the 2008/9 bear market, the prudential medium equity and the prudential variable equity sub-categories recorded maximum average year-on-year losses of 17.3 percent and 14.6 percent over that 12-month period.

Although investors in the prudential low equity sub-category were generally spared such large losses, they did incur an average year-on-year loss of 4.7 percent over the 12 months to October 2008. One fund in this sub-category was down by as much as 15.7 percent.

When the worst returns are considered, the spreads between the biggest and the smallest year-on-year losses (and in some cases small gains) over the 10-and-a-half years in each sub-category are extremely wide. There was a 39.1 percentage point difference between the biggest loser and the fund with the smallest loss over any 12-month period in the domestic equity general sub-category.

In the prudential variable equity sub-category, the difference between the smallest and the biggest loser was 34.9 percent; and in the prudential low equity sub-category the difference was 22.3 percent.

You should therefore ascertain whether the risk of your fund incurring losses – the downside risk of your fund – is not at the higher end compared with the other funds in its sub-category, De Klerk says.

You can reduce the risk of losses by moving out of higher-risk funds into lower-risk funds in the same asset class sub-category, he says.

Reducing risk is one of the reasons you pay management fees to a fund manager, De Klerk says.

Passive investments, such as exchange traded funds, may be low cost, but they do not offer you the benefit of a fund manager who can limit the losses you may incur when markets turn against you, he says.

It is true that most of the time the funds and/or asset classes that produce the worst losses are also likely to perform the best when the equity market recovers from a deep bear market, De Klerk says.

But what if something happens to you, as an investor – for example, you lose your job, become disabled, fall ill or die prematurely? You may not live or work long enough to recover the losses you sustained, he says.

WHAT YOU SHOULD DO

You need to consider whether you can afford to have your investment values fall to the extent that they have over any rolling 12-month period since the fund was established, Ryk de Klerk, the executive director of PlexCrown Fund Ratings, says.

You or your financial adviser can ask your fund manager for the history of the investment’s losses over rolling 12-month periods, and you can also use the PlexCrown Risk Classification Index (free at www.plexcrown.com), which covers all South African unit trust funds. The index provides you with an indication of the risk your fund has of incurring a large loss at any time. The index is calculated on the basis of monthly downside risk over rolling seven-year periods. Funds are classified from one to 10, with one representing the lowest risk.

MINIMISING RISK WHEN YOU’RE DRAWING AN INCOME

Minimising the risk of losses for an investor in a product such as a living annuity is hugely important because regular monthly withdrawals (outflows) on negative returns or a declining portfolio value compound over time, Daniel Wessels, a financial adviser with Martin Eksteen Jordaan Wessels, says.

He says drawing income from a declining portfolio has the same effect as compounded interest but in the reverse, with disastrous consequences for investors, whose retirement capital is depleted.

Therefore, asset allocation and fund selection is crucial – and it is best to consult investment experts to structure your portfolio, Wessels says. Too often investors think they can do it themselves, with dire consequences if they are not careful or aware of all possibilities, he says.

Wessels says it may be optimistic to expect an equity fund manager to better protect you against a major market correction, because managers don’t have crystal balls. However, at this week’s African Cup of Investment Management conference in Cape Town, André Perold, a former Harvard Business School professor, argued that managers could better manage short-term risks because volatility indices are quite good indicators of short-term risk.

Wessels says an actively managed fund may lose less than an index equity fund simply because the active fund always has a cash portion (say 10 percent) whereas the index fund has very little cash.

Within equity exchange traded funds (ETFs), the risk profile of each fund is also different, Wessels says, with some ETFs tracking indices with a high concentration of shares and a higher risk of incurring losses, such as the FTSE/JSE Top 40 index, and others tracking those with more equal weightings and lower risks, such as the Shareholder Weighted index (Swix40).

Louis Niemand, an investment specialist at Investec Asset Management, says certain unit trust sub-categories, such as asset allocation flexible, are confusing for investors, as the underlying funds cannot be compared on a like-for-like basis. The sub-category includes funds managed extremely conservatively, with a very low allocation to equities, and funds that have close to 100-percent equity exposure over time.

You must be sure you understand the investment objective and strategy of your chosen fund, Niemand says.

• Don’t panic, say asset managers