Page 110 - Profile's Unit Trusts & Collective Investments - March 2025

CHAPTER 6

invested as possible, while others are permitted to operate within the requirements of the ASISA
guidelines, which would allow, for example, a general equity fund to be as much as 20% liquid.
Liquidity can have a significant impact on performance.
A general equity fund which is 20% liquid in a bear phase is not as exposed to the falling market, but
the same liquidity level in a strong bull phase will almost certainly cause the fund to under-perform.

Stock Picking Risk
As we said earlier, having all your eggs in one basket is a great strategy – provided you pick the
right basket.
One way to achieve superior returns is to concentrate your investments in a smaller number of
winning shares. This is something that Warren Buffet is famous for, and Mr Buffet’s wealth is
testimony to the success of this strategy. There is no question, however, that all things being
equal, concentrating on a smaller number of stocks generally increases the risk level. Stock picking
requires in-depth knowledge of the market, the economy and particular companies.
Stock picking risk can, of course, be reduced through diversification. Index funds are an
effective way of almost eliminating stock picking risk, because they aim to mirror the performance
of a market index and are therefore only exposed to particular shares to the extent the index itself
is exposed. When it comes to actively managed equity funds, which rely considerably on stock
picking, the proven track record of the fund manager is an important consideration.

Measuring Risk
As mentioned earlier in this chapter, risk is hard to define – the word means different things to
different people. How to measure or quantify risk can, therefore, be a contentious issue.
Some common measures of the riskiness of unit trusts are volatility, beta, alpha, maximum
drawdown and r-squared. (Ratios like Sharpe and Sortino also address risk but provide
risk-adjusted returns rather than “pure” risk measures.)

Active Returns
The types of risk covered in the previous section can broadly be divided into two categories: on
the one hand, risks inherent in assets classes and where they are domiciled, and on the other, risks
associated with decisions made by fund managers and investors.
As we have seen, the performance of asset classes (and sectors or sub-divisions within assets
classes) are measured by indices which are used as performance and risk benchmarks. A long-term
investment which replicates an index or benchmark, known as a passive investment, is mainly
subject to benchmark risk – ie, because the investor or fund manager is simply riding the ups and
downs of the asset class or sector, the risk factors associated with stock picking and market timing
are minimised or precluded.
The investment returns produced by a particular asset class or sector (as measured by a
benchmark) can be referred to as passive returns – ie, the investment performance inherent in the
benchmark. An active return, by contrast, is the difference between an actual investment return and
the return of the investment’s benchmark. This active return must be attributed to decisions made
by the fund manager or investor, ie, the active return is the result of active management.
The concepts of passive and active returns are important in the unit trust industry because the role
of most fund managers is to achieve active returns – to outperform benchmarks. (The exceptions are
“passive fund managers” but this term is almost a misnomer – the manager of a passive fund is not so
much “managing” the fund as ensuring that it conforms to a benchmark.) Investors in an actively
managed fund are, as a rule, hoping for performance in excess of the benchmark.

Alpha
By introducing stock picking risk and other fund manager risks, active fund management often
increasesthe overall riskinessofafund –atleast compared to its benchmark. (Sometimes, of course,
active fund management can decrease riskiness, although this is less common.)

108 Profile’s Unit Trusts & Collective Investments — Understanding Unit Trusts