FY23 fund returns: When details and context matter

I came across the following eye-witness report a number of years ago.

A fund manager is presenting his fund's performance and proudly announces: average return over the past two years is 25% per annum.

One disgruntled attendee in the audience stands up from his chair and shouts: I'm calling BS! I personally have invested in your fund and I can tell everyone the fund hasn't gone anywhere since.

Fund manager, unperturbed, moves to the following slide showing his fund gained 100% in year-1, then declined by -50% in year-2. 100 minus 50 = 50, divided by 2 = 25%.

I've never established whether this anecdote actually took place in real life, but the underlying message remains unchanged: investors should remain cognisant of how finance generally is covered and reported on, while always trying to ascertain whether the finer details do not contradict the headline impressions, or offer a much more insightful background and context.

Those among you who may not be great with mathematics might now be thinking: what's wrong with the story above? Who's correct and who's not?

The straightforward answer is there's a lot wrong with that story, but also: both the fund manager and the angry investor are correct. The fund manager, however, is using the audience's dislike for maths and details to his own advantage, like a good old snake oil salesman.

Like with so many things in finance; one needs both a broader context and the finer details to get to the true picture.

In the example above: if an investor had invested from day one in Year-1, say $30,000, then that capital would have first doubled to $60,000 (100% gain) but subsequently reverted back to the original investment as that is what a decline by half (-50%) amounts to.

The result is a great outcome for marketing purposes (25% per annum!) but not great at all for the investor whose capital went backwards because of fees and inflation.

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In the never-ending debate between actively managed investment funds and passive ETFs and other listed instruments, it is my observation many a professional investor knows how to outperform the broader market during times of plenty of sunshine (Risk On, bull markets) when taking on risk gets rewarded in spades, but things can go off the rails quite quickly, and quite devastatingly so, when the overall market environment deteriorates.

Investors might keep this in mind over the coming weeks as fund managers and industry consultants are no doubt preparing for a Good News marketing story.

The ASX200 Accumulation index, which includes the dividends paid out throughout the year, has generated a return of no less than 14.78% for the year ending on June 30. Some foreign indices have even done significantly better.

A few things to keep in mind:

-In Australia, the market performed best in H1 while in H2 the bulk of returns were generated in the June rally, which subsequently evaporated again in July

-Such environment usually emphasises the importance of dividends, but banks have been weak in 2023, with the market preferring insurers instead

-While the lists of top performers all contain small caps, it's been a heavily polarised landscape and large caps, as a group, have outperformed their smaller peers

-FY23 has once again highlighted the sweet spot in the Australian share market lays inside the MidCap50; effectively the ASX100 minus the Top50

-The final month of FY22 saw markets take a deep dive into the abyss, creating a low point from which this year's 12 month returns are being calculated

The importance of not simply staring oneself blind on twelve month's performance numbers shows up in many forms and disguises. Take Perpetual's global innovation fund, for example.

With a return of 44%, the fund is sitting on top of Morningstar's performance rankings for FY23. No questions about it, this is a fantastic outcome, but it looks a whole lot less impressive when we take into account this fund lost nearly -50% in the previous year.

Let's assume our angry investor in the opening anecdote had taken his $30,000 and given it to the Perpetual fund to manage two years ago. Today, his capital would have eroded to $30k minus 50% = $15,000 times 44% = $21,600, meaning he effectively lost -$8,400 over that period.

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One intriguing observation is the repeated relative outperformance in Australia of the MidCap50; that segment of companies not large enough to be part of the ASX50 but on average too large to be included with the many smaller caps listed on the ASX.

Talk to any small cap investor this year and they will assure you times have been extraordinarily challenging. The S&P/ASX Small Ordinaries, for example, generated 8.45% in FY23 total return, but only 1.32% for the first six months of 2023.

In comparison, the MidCap50 is up 4.60% for the six months ending June 30, which is similar to the ASX50, but for the full financial year the gain is 17.97%. Over three years (13.50%), five years (8.80%) and ten years (14.40%) - the outperformance from this segment on the exchange is quite persistent.

Do we know why? Are there any conclusions or insights we can draw from it?

My own view is this segment includes those success stories from the small caps space that are able to grow into a much larger size, and ultimately become part of the ASX50 large caps.

Micro caps and small cap companies will always have an attraction, because such companies can grow rapidly from a low starting point, which can translate into outsized share price gains in a short time. But only few can turn that operational momentum into a sustainable, long-term growth story.

In other words: the best out of the bunch eventually end up in the first half of the ASX200, and if they're truly successful they continue advancing through the rankings until they leave this segment through the front door, i.e. they join the ASX50. Another way of approaching it is through the balance between risk and reward.

Since companies that keep climbing through the ranks have proven the merits and success of their products and services, I'd argue they represent a much better risk-reward balance, in between smaller peers that yet have to prove themselves and the larger sized companies that can be quite sluggish in their growth.

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When it comes to investing and the share market, Mike Tyson described the experience of the past years best: "Everybody has a plan until they get punched in the mouth".

Wall Street legend Bob Farrell's rule number ten also springs to mind: Bull markets are more fun than bear markets.

To say that events, extreme polarisations and momentum switches have tested investors to the max in the three years past can only be a grave understatement. 

While much of today's public discourse is whether equities are still in a bear market or not, a prudent investor would be prepared for challenging times ahead.

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