According to Morningstar, there are 22,689 mutual funds, 1,457 ETFs, 14,422 stocks, and I couldn’t even venture a guess as to the number of municipal, corporate and government securities on the market. Moreover, there are a number of additional investments such as UITs, CEFs, REITs, MLPs, tangible assets and more. For advisors, sifting through the multitude of information in the investment universe is a daunting task to say the least.
For advisors who use mutual funds and exchange-traded funds, this article should hold special interest. In it I will share a process that I began developing about four years ago. After much tweaking, it has been refined to a point where my ability to select and maintain high-quality funds has been greatly enhanced. I call this tool my Fiduciary Scorecard. Unlike the majority of programs used to select funds, the Fiduciary Scorecard utilizes a ranking system rather than the problematic screen.
Screens Have Holes
Most investment programs utilize screens. For example, let’s say you were searching for large-cap funds with a trailing one-, three- and five-year category rank in the top 50th percentile. Some funds may meet the criteria in two periods, but miss it in the third and would be eliminated. This is true even if a fund missed the third time period by only one percentage point. Screens will eliminate everything that doesn’t meet their strict guidelines. This may not pose a problem if your screen only contains one criterion, but if your screen includes multiple criteria, you could be eliminating many good funds.
Although my process begins with a screen, it is a very basic one. For example, I will screen for large-cap domestic value stocks with more than 80% invested in America. The result is a fairly large universe. Then, each fund is ranked by the Fiduciary Scorecard. In this way, a fund won’t be eliminated, but if it happens to be a regular visitor in the third or fourth performance quartile, it may receive a lower score.
When I embarked on my road to independence several years ago, I needed software to help with fund selection. Although most applied some sort of screen, there were a few outliers. One such tool was from Klein Decisions. Klein has developed a system whereby you can select the data you deem most relevant. Another program I especially liked was from fi360 that analyzed and scored funds according to fiduciary standards. Although both programs were good, being the financially frugal person I am and considering they used data I didn’t believe to be important, I decided to create an alternative.
When you consider the amount of information available, you quickly get a sense of the challenge one faces when selecting funds. In the course of my research, I discovered that some data is more important than others. This belief was reinforced after reading Russel Kinnel’s book, “Fund Spy.” Kinnel is the director of mutual fund research at Morningstar. He found certain data held greater significance in identifying future outperformers.
The process of building a portfolio of funds and ETFs involves three basic steps. First, you must identify which categories have the greatest potential to outperform given your particular global macro economic outlook. Next, you must search for the best funds and ETFs within these categories. Finally, you must determine the amount to be allocated to each fund. We will focus our attention on fund selection.
In the scoring process, each fund is measured against its specific peer group and not against the entire universe. Also, a fund with a higher score is preferred to a fund with a lower score and all data is from Morningstar.
The Five Broad Categories
There are five main areas included in a fund’s fiduciary score: absolute risk, relative risk, expense, stability and relative performance (See Figure 1, below). Let’s drill down and take a closer look at each category and how points are awarded.
Absolute Risk. Absolute risk is a measure of a fund’s fluctuation without regard to performance. To gauge a fund’s absolute risk over the past three and five years, I use standard deviation. If a fund’s standard deviation is 25% or more lower than its peer group average, it receives two points. If it is 0% to 24% below its category average, it receives one point. Otherwise, no points are awarded.
Absolute Risk’s contribution to final score: 6.6%.
Relative Return. Relative risk is a measure of how well a fund performs given the amount of risk it assumes. Funds with greater risk should compensate investors with a higher return. Each fund is ranked within its peer group on a risk-adjusted basis using Sharpe ratio, alpha, information ratio and risk/return.
- Sharpe Ratio. The Sharpe ratio is a risk-adjusted measure used to determine an investment’s excess return per unit of risk. Its formula incorporates the standard deviation and the risk-free rate. If a fund’s Sharpe ratio is greater than the average for its category over the trailing three-year period, it receives four points. Otherwise, no points are assigned.
- Alpha. Alpha can be useful in determining how much value a manager has added. Alpha is most useful when comparing funds with similar investment objectives. If a fund’s alpha exceeds its category average for the trailing three-year period, it receives four points. Otherwise, no points are awarded.
- Information Ratio. Unlike the Sharpe ratio, this risk-adjusted ratio replaces standard deviation with a specific benchmark index. Because the IR is affected by a fund’s tracking error, and because I don’t believe tracking error is particularly useful, it receives a lower point total than the other relative risk measures. If a fund’s IR is above its peer group average for the trailing three-year period, it earns three points. Otherwise, no points are given.
- Morningstar Risk/Return. Morningstar risk is an assessment of the variations in a fund’s monthly returns with an emphasis on downward variation. I’ll forgo divulging their secret sauce, but will mention that the top 10% of funds are given a risk score of five or “High”; the next 22.5% are scored four or “Above Average”; the next 35% are scored three or “Average”; the next 22.5% are scored two or “Below Average”; the bottom 10% are scored one or “Low.”
Morningstar return is an assessment of an investment’s excess return over a risk-free rate (e.g., the return of the 90-day Treasury bill), the results of which are similarly divided into one of the five aforementioned categories.
Using the trailing three- and five-year periods for each, here’s how I score them: Let’s assume a fund has a risk profile of Average. We would expect the return to be at least Average and hopefully higher. If a fund has a risk profile of Low and a return profile of High (the best possible outcome), the difference between the two is four sigma. In scoring, if there is four sigma difference, it receives the maximum number of points: five. If there is a three sigma difference, it receives four points, and so on. If the risk and return are equal, it receives one point. If, however, the risk is higher than the return (not desirable) no points are awarded.
Relative Risk’s total contribution to final score: 35%.