When You Evaluate a Fund Manager, Look Beyond Results

When You Evaluate a Fund Manager, Look Beyond Results


THIS Sunday will be five years to the day since the low point for the Standard & Poor’s 500 stock-index during the Great Recession. Since bottoming out on March 9, 2009, at 676.53, the index has risen some 170 percent.

Passing the five-year mark may be cause for celebration, but it also allows mutual fund managers to report better performance. Starting next quarter, the losses from the financial collapse will no longer be included in the five-year picture.

“The numbers are going to change dramatically,” said Joe Jennings, investment director for PNC Wealth Management in Baltimore. “You lose one quarter, but it’s going to make a significant difference.”

He said the impact of the new numbers could be the greatest among younger people who had a bad first experience as investors and have consequently stayed away from equities. “Now, they’re going to start to realize markets don’t always perform that poorly,” he said.

Yet there will be another significant effect of these impending spruced-up returns. Investors are going to be skeptical of funds that promote their five-year returns, knowing that those numbers paint an incomplete picture.

“Generally speaking, investors are smarter now than they were five years ago,” said Daniel Jacoby, chief investment officer of Stratos Wealth Partners. “They’re more untrusting. If fund companies try to hide from the drawdowns, they’re going to ask questions, and that makes investors more defensive.”

While every fund prospectus carries the disclaimer that past performance does not guarantee future returns, the past, in some form, is all investors have to go on to judge a manager’s skill — even though what matters is what the manager can do in the future. Here are some suggestions for delving deeper into a manager’s track record so that you don’t pick one whose performance will get an undeserved boost with the new quarter.

FULL CYCLE Any period in which a manager’s returns are judged is going to be arbitrary. When the period started can make a huge difference.

Steven M. Krawick, president of West Chester Capital Advisors, pointed to the current five-year trailing returns for the fund Legg Mason Opportunity I. The fund, which was the best performer last year, averaged a 36.33 percent annual return in the five years ending Feb. 28, 2014, according to Bloomberg. But that period excluded the fund’s 65 percent drop in value in 2008. If a six-year return were taken, also ending last month, the return would be 5.97 percent a year — below what the S.&P. 500 did for the same period.

Mr. Krawick said he preferred to evaluate managers through a market cycle. “I think five-year trailing returns are only appropriate if you had a full bear and bull market,” he said. “If you’re not looking at a complete market cycle, you’re only looking at one side of a manager’s ability.” And in the last five years, stocks have gone mostly up.

REPRESENTATIVE YEAR According to Morningstar, more than 60 percent of the 7,496 mutual funds in the United States today have been created in the last 10 years — and a third in the last five years — so looking at long-term performance may not even be an option. Several advisers prefer to look at just one year. While it might seem too short a period to judge a manager’s skill, advisers say it depends on the year.

Trying to glean anything from 2008 and 2013 would not be helpful, since stock markets largely went down in 2008 and up in 2013. But a year like 2011 is one that advisers focus on to assess a manager.

Also, “2011 was a great year to study because we experienced outsized intrayear volatility and performance was essentially flat on the S.&P. 500,” Mr. Jacoby said. “Understanding how fund managers were positioned in this type of market will shed a lot of light on how they view and manage risk.”

Choosing a year in which there were large macroeconomic events, like the financial meltdown in 2008, is not a good reflection of an individual manager’s ability to pick one stock over another, because good and bad stocks were moving together.

“If you don’t know if the world is going to end or not, no one really cares about one company versus another,” said Chris Blum, global head of equities at J. P. Morgan Private Bank. “It doesn’t matter what multiple a company trades against another or their earnings growth.”

BETTER METRICS The next layer down is to look at metrics that can tell you the quality of the returns.

A fund’s standard deviation will tell you how volatile a manager’s strategy is. The higher or more volatile it is, the more likely an investor could get scared and sell before the strategy plays out. “People want consistency and stability,” Mr. Krawick said. In his example of the Legg Mason Opportunity fund, the standard deviation was a wild 23.81, according to Morningstar.



Investors want low volatility, says Steven Krawick, president of West Chester Capital Advisors. CreditJeff Swensen for The New York Times

The Sharpe ratio, a method for measuring risk-adjusted return, can help assess one manager’s skill in achieving a return versus another manager’s willingness to take a lot of risk. Someone who took very little risk to get to an 8 percent return is better off than someone who made 8 percent but should have made 12 percent given the amount of risk in the investments. The higher the Sharpe ratio, the better.

Since funds do not always rise, there is the Sortino ratio, which measures a fund’s volatility on the downside. As with the Sharpe ratio, the higher it is, the better, because it means the manager has a strategy in place so the fund doesn’t absorb all the losses in a down market.

Then there is the information ratio. It measures a manager’s skill in delivering returns relative to a benchmark with less volatility along the way. The managers whose returns look like a straight line are better than those that look like a sine curve.

STYLE POINTS In conjunction with the quantitative is the qualitative. How does a manager do what he says he is going to do? This is a lot like showing the calculations that got you to the correct answer.

Mr. Blum says he looks for managers who have a well-reasoned process for making investments and who can stick to that process. He said he was more forgiving of a manager who goes through a rough patch if he has a process that he understands. He is less trusting of managers who suddenly change what they’re doing to achieve returns.

“If someone calls themselves a large-cap growth manager but they’re sitting in small-cap value stocks, I’d question that,” Mr. Blum said.

More difficult to assess are newer funds that can invest in various securities. BlackRock has several bond funds that can also invest a significant percentage of their assets in different types of bonds or stocks.

“These unconstrained bond funds look terrific, but they could be 20 percent in equities,” said John W. Rafal, founder and vice chairman of Essex Financial Services. “We have to be careful with what they own and how they did it. What is the correlation to a benchmark?”

ASKING FOR EXPLANATIONS The easiest advice may be to talk to the fund managers and understand how they think about what they’re doing — something average investors cannot do, but their advisers presumably can.

Gene Goldman, vice president for research at the Cetera Financial Group, said his firm tracked rolling 12-month returns on the funds it monitors to compare them to their peers. He had liked the Edgewood Growth Fund, which remained near the top of its peer group since he had tracked it, but he was worried when it suddenly dropped in 2010. So he called the fund managers.

“We basically said, ‘We’ve known you since 2005, what happened?’ ” Mr. Goldman said. “They said, ‘We made two stock mistakes. We misinterpreted market signals.’”

Since managers make mistakes like anyone else, Mr. Goldman asked them what they had done to improve their stock picking. “They said now if a stock drops more than 20 percent, they move it into a penalty box and another manager who didn’t recommend it evaluates it,” he said.

Mr. Goldman said he found this reasonable. More broadly, he said he always looked to gather as many data points as he could to make a decision on a manager’s performance. “They all come in with their canned stories,” he said. “We want to pelt them with questions so that when things are going crazy in the markets, you have confidence in who is navigating the ship.”


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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