Assessing Fund Performance

How would you assess fund performance?

This month I am going to continue a little with my discussions about investment and in particular the work of a fund manager and how an investor might assess fund performance. I would like to reiterate that these are topics that should be of importance to virtually every investor.

Understanding how a fund is managed is of vital importance if you (the investor) plan to choose an investment that is appropriate for you. A major element in choosing a fund is obviously going to be the result it produces. But just how do you compare or interpret those results?

Most fund managers (unless we are specifically looking at the hedge fund industry) will not consider their absolute return to be a worthwhile number to follow. The absolute return is obviously important to them and to us. It is not however, usually of overall importance to the industry.

For example, if fund A achieved a return of 5% in a quarter, we might consider that to be a great return. But, if most of the other funds in that same sector produced returns of 10% in the same time, we didn't really do so well. If the area in which our funds are investing actually increased by 11%, then we received an even worse return.

Therefore, it is important that any fund performance results are compared to other measures. These measures often include:

A relevant stock market index

A peergroup comparison

A two horse race between comparable funds

The median manager where comparison is made against a similar group

Whilst these types of measures may seem appropriate at first sight, they do not necessarily fit into the criteria that we may wish for a good benchmark. For example, if I were to pick the criteria of a benchmark, it might include:

Being investable - the fund manager or investor needs to be able to invest in a way that mimics the benchmark closely. If this is not possible, the benchmark becomes purely theoretical and probably impossible.

Measurable - some areas of finance (commercial property for example) are very difficult to either measure or compare.

Specified in advance - the aim of the fund and benchmark to be used should be selected at the outset, preferably in the statement of principles of the fund.

Have a similar risk level - the style of manager / fund must be considered.

This last criterium, risk, is of vital importance to this discussion. When comparing funds and fund manager abilities accurately. The level of risk they have taken is often likely to be a deciding factor. It cannot be meaningful to compare a small cap fund manager with the FTSE 100, the two are simply not alike. It is in these circumstances that a neutral benchmark is vital.

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If a stock market index is to be used, it must be chosen wisely. If this is not done, then a benchmark portfolio can easily be created. A preset collection of stocks can be chosen that are believed to broadly represent the sector or area of investment. At the end of the monitoring period, a comparison can be made to the fund. This is of course an ongoing weekly, monthly, quarterly and annual process.

Suddenly, you may be realising that there is quite a lot to this. As with everything in the world of investment, nothing is as simple as it seems. This is a problem for the fund management industry. Making fund performance statistics easily digestable for the masses is clearly not a simple task.

As an advisor, this is a topic that never fails to make me cringe. When a client looks at a list of fund performance figures and asks for an explanation, the answer is never easy. In fact, it can be hell-ish complicated.

Firstly, I might not know the answer. I'm human, I can admit this. I may not know because I didn't anticipate the question and investigate in advance, the information may not be readily available or simply I should know but cannot remember.

However, if I am prepared and have expected some enquiry (as there are some pretty common questions) I am still faced with trying to explain the answer in terms that people can comprehend. My client base is a fairly intellignent and sophisticated bunch, but they do not have an investment background which means that my answer is still likely to be largely incomprehensible to them. High fallutin gibberish is still gibberish.

I need to explain that the index or benchmark being compared against is made up largely of X, Y and Z type investments, whilst your fund is mostly X and Z with a little W thrown in. It is this difference and extra W that has had the (positive or negative) impact. However, the fund is not at all like the FTSE 100 (or whatever index they see on TV) and so the fact that the market is generally rising / falling, does / does not have a great impact on your fund. This is because...

It is often at this point that I need to wake them up! If I go much further, they may slip into a coma caused by something that the medical profession calls a 'serious head trauma'. And you thought that they were mainly caused by car accidents!

I have long held a theory that buried deep in the recesses of the medical profession is statistical information proving that trying to understand financial reports causes xx number of serious injuries per year.

The fund management industry has done a lot to make these comparisons simpler, but at the same time, created much extra confusion. As ever more funds become available in tight, niche investment sectors, new benchmarks need to be created for comparison purposes. More funds and more benchmarks equal an exponential increase in confusion. Even for guys like me.

*This article was first sent to my newsletter subscribers in Oct. 2006*

For articles relating to similar topics, please visit these pages:

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