If predicting the future is hard, choosing a money manager who will outperform the market and his peers is doubly so.
For proof of this fact, look no further than Morningstar's rating system: Five-star funds as a group do not outperform going forward, studies show.
But that doesn't mean that advisors have no tools at their disposal for vetting managers and for getting some clues as to how they might perform. Some of the best are as follows:
Beta: Measuring Volatility
The first future-looking measure is beta, which pegs a portfolio's (or security's) volatility to a benchmark, such as the S&P 500 Index, and indicates how the portfolio should perform given the movements of that benchmark.
A colleague of mine, Don Berryman, uses the following analogy to explain the concept of beta: “Think of two portfolios as sailboats. Given the same wind conditions (the market), the boat with the bigger sail (beta) will move the most.”
A beta of 1.0 means the portfolio should have a return similar to that of the benchmark. If the beta exceeds 1.0, expect more volatility; if it's less than 1.0, expect less.
For example, if the beta on a portfolio is 1.2 and the benchmark gains 10 percent, the portfolio should rise about 12 percent (1.2×10 percent). If the index falls 8 percent, the portfolio should lose about 9.6 percent (1.2 × -8 percent). A beta that's higher than the benchmark means more volatility in both directions.
Alpha: Measuring “Added Value”
Knowing the beta will help in evaluating the performance of a portfolio. But there is more to it, especially when returns deviate from the expected beta values. This is where alpha comes in.
Alpha is the difference between the return expected, given the beta, and the actual return of the portfolio. The alpha can be positive or negative.
For example, let's say the benchmark returned 12 percent, and the beta on your client's portfolio is 1.1, placing the expected return of the portfolio at 13.2 percent. If the actual portfolio return came in at 15 percent, its alpha is 1.8 (15.0-13.2=1.8). If, by contrast, the actual portfolio return was 9.5 percent, we would have an alpha of — 3.7.
So, what does the alpha tell you? In short, it's the value added (or subtracted) by the manager. In the first scenario above, the manager's actual return exceeded the expected return by almost 2 percent. In the second case, the portfolio under-performed by 3.7 percent.
R-Squared — How Accurate Is Everything Else?
R-squared explains how closely the movement of a portfolio's return relates to its benchmark. It is a measure of correlation. Over time, if the returns of a portfolio and benchmark behave in a similar manner, they are positively correlated. If they move in opposite directions, they are negatively correlated.
Here's a useful analogy to explain it: A car wash and a gas station sit side-by-side on a busy street. For the car wash owner, weather is almost everything — if it rains, few, if any, cars are likely to buy his services. By contrast, the gas station gets a steady stream of business rain or shine. In other words, the predictability of car wash sales in relation to weather is high, while the predictability of gas sales is low.
Risk-Adjusted Return
In basic terms, the risk-adjusted return (RAR) of a portfolio is the measure of how much an investment returned in relation to the amount of risk it took. Three formulas allow us to compare disparate portfolios on an “apples-to-apples” basis: Sharpe, Sortino and Treynor measures.
The Sharpe Ratio adjusts the return of the portfolio based on the amount of risk taken to achieve it. It indicates how much excess return was achieved per unit of total risk, as measured by standard deviation. Similarly, the Sortino Ratio measures return earned per unit of downside risk. The Treynor Ratio measures return earned per unit of beta, or market risk.
Though no single risk-return statistic is a perfect performance measurement tool, together the ones mentioned above can offer a relatively clear picture of how well a portfolio will perform. Used in conjunction with more subjective manager evaluation questions — such as those in last month's column — they can provide you and your clients with a much better understanding of the manager and his/her ability to help your clients reach their financial goals.
Writer's BIO:
Steve Gresham is executive vice president and chief sales and marketing officer for the private client group of Phoenix Investment Partners, Ltd. He's the author of The Managed Account Handbook: How to Build Your Financial Advisory Practice Using Separately Managed Accounts and Attract and Retain the Affluent Investor: Winning Tactics for Today's Financial Advisor. [email protected]
