Sunday, January 4, 2009

Fund Managers Skills

Fund Manager need 2 skills to outperform the market.
1) The skill of forecasting price movements of selected stocks. It is best described as "Security Analysis" or simply "Stock Picking"
2) The skill of forecasting future economic conditions and adjust portfolio systematic risk. This is best described as "Market Timing"

Many people only looks at the returns of their fund to guage if they are investing well and not comparing this returns to anything else. I think this practice can be improved by looking into some technical aspect of the fund.

So what are the technical areas we can look into when we analyse fund managers? With my limited knowledge, I can share 5 simple and more reader friendly ones.

1) The Annualised Returns
* The absolute returns of a fund above 1 year are first annualised and compared with the benchmark and peer funds.
* If the fund outperformed the benchmark, we can say that it had generated excess returns over the period. 1,3 and 5 years of returns are normally used.
* Thereafter, we use the figure to compare between fund managers. Its like a soccer league table where we see who top the table for each category.

However, by knowing returns alone are not sufficient, we have to know the type of risk the fund manager is taking in order to generate this excess returns.

2) Fund's Beta
* Beta is the primary measure for market risk of an investment. It measures the volatility of an investment in relation to the overall market. The overall market has a Beta of 1. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile.
* For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.

3) Standard Deviation
*Another way to see the level of risk a fund manager take is by looking into the fund's Standard Deviation.
* Standard deviation is a statistical measurement on historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.

After understanding Returns and Risk, we need to combine both to evaluate if the fund manager is really doing fine.

4) Sharpe Ratio
* William F. Sharpe developed the Sharpe Measure in 1966 to evaluate portfolio performance. His idea was to measure the amount of excess return of the portfolio over the risk-free rate in a given period per unit of risk.
* It indicates the excess return that the fund manager can deliver to investors for each unit of risk the fund manager took. Hence, the higher the Sharpe ratio, the better the investment's performance.

5) Fund's "Alpha"
* It measures the difference between a fund's actual returns and its expected performance, given its level of risk (as measured by beta).
* A positive alpha indicates that the fund has performed better than its beta would predict. In contrast, a negative alpha indicates a fund has underperformed based on the risk it had taken.
* A fund manager always strive to achieve positive alpha consistently.

The ratios that can be used are exhaustive and the above are very basic ones. Many other ratios such as Information Ratio, Jenson Ratio, Tracking Error, R Squared, etc are not mentioned. Frankly, I'm not an expert is these as well and certainly not good enough to conduct a class on them.

We are nevertheless fortunate to have Investment Information Providers such as Morningstar and Lipper to help group fund managers' ability according to their methodology which partly use these ratios.


Anonymous said...

Many fund managers have no real skills. Their seemingly high return is usually done by having high beta but their alphas are usually negative. High beta can be easily achieve by overweight small cap or under valued companies. In recent times, using of leverage is also quite easy say going into leveraged ETF and CFDs. The use of leverage increases beta.

I suggest using index funds. Index funds have a perfect beta of 1 and alpha of zero. It will never underperform the market.

Anonymous said...

Very few managers outperformed . If the whole idea of actively managing to outperform then it is better to buy index funds. This explains why ETFs are popular.

Anonymous said...

Unfortunately very few financial advisers will recommend ETFs because it pays no commission.

Anonymous said...

Easy to say that, however, there does not seem to be a index fund in Singapore.

The closest is ETF, but that is not an index fund, strictly speaking.


Anonymous said...

An ETF is good enough. In fact, many ETFs have expense ratio lower than a index mutual fund.