How good are financial advisors at measuring the performance of mutual fund managers? Among retail investors, the use of inaccurate yardsticks like fund ratings and peer-group comparisons is fairly common.
Hopefully, advisors aren’t making many, if any of, the same mistakes.
Let’s examine three better ways to successfully judge fund performance.
1. Don’t use peer group analysis
Many mutual fund analysts lead their followers astray by focusing on mutual-fund performance relative to its corresponding peer group. In truth, the correct measure should be fund performance versus a corresponding benchmark index.
"Peer group" comparisons are dangerous,” explains William F. Sharpe, a Nobel Prize winner in economics. “Because the capitalization-weighted average performance of active managers will be inferior to that of a passive alternative, the former constitutes a poor measure for decision-making purposes. And because most peer-group averages are not capitalization-weighted, they are subject to additional biases.”
How would this work in a real-life application?
For instance, you should compare international stock funds to international stock yardsticks like the MSCI EAFE Index (EFA).
Likewise, small- and mid-cap stock funds should be benchmarked to small- and mid-cap index funds like the S&P MidCap 400 (MDY) or the iShares Russell 2000 Index Fund (IWM). Since ETFs tracking these benchmarks are readily available, monitoring relative performance is fairly easy.
Remember to always compare apples with apples and oranges with oranges. And finally, always make sure you compare performance over the same time period.
2. Beware of closet indexers
Do your clients own active mutual funds that aren’t really that active?
A closet index fund is an actively managed fund that closely mimics the volatility and performance of an index fund. How does it happen?
As mutual funds grow their assets, they buy more securities in order to reduce over-concentrated positions. Some fund companies will purposely avoid making large bets on certain stocks or bonds to avoid the risk of making a lousy call and badly underperforming.
What’s the final result? A mutual-fund portfolio that looks and acts just like an index fund, but charges substantially higher fees.
How can you make sure you don’t own a closet index fund? One way is to evaluate your fund’s R-squared or R2.
The R-squared measures the correlation of a fund’s movement in comparison to its corresponding benchmark. An R-squared score of 1.00 would indicate a perfect correlation, whereas a score of 0.00 indicates no correlation.
Think twice about owning any actively managed mutual funds with an R-squared above 95. It could be the sure sign of a benchmark hugger!
3. Avoid high turnover funds
Is your mutual fund manager a long-term investor like they preach or are they an imposter? One way to find out is to examine the churn or turnover rate of holdings within your mutual fund’s portfolio.
Portfolio turnover measures the frequency by which securities within a mutual fund are bought and sold. A churn rate of 100% indicates the fund manager has sold the fund’s entire portfolio and bought new holdings during the course of a year. Turnover is determined by the dollar value of buys or sells (whichever is less) during a year divided by the total assets in the fund.
High portfolio turnover translates into higher investment costs, whereas low portfolio turnover is better because it lessens the impact of trading and tax related expenses. The fact that index funds and ETFs have a low turnover rate makes them an attractive investment choice.
In summary, these three simple yardsticks can help advisors to make sure their mutual funds are staying on track.