by WWM | May 9, 2018 | Mutual Funds
In Mutual Funds: Diversification I, we considered the level of diversification within a potential mutual fund.
There may be 100 plus holdings in a fund, but that does not guarantee a well diversified mix. I recommended reviewing the percentage of total fund assets held in the top 3, 10, or 20 holdings. If the fund holds 100 companies, but the top 10 holdings make up 40% of total assets, the fund may not be as diversified as you expect. As well, you should compare the concentration of key holdings between different funds within the same peer group and benchmarks. The distributions should be similar. If not, ask why.
Next, consider the inter-fund portfolio analysis of assets. If you invest in multiple funds, it is equally important to compare actual holdings between the different funds. If not, you may end up with too much exposure to the same investments.
Avoid Investing in the “Same” Fund Twice
In essence, you pay additional management fees for acquiring the same assets. A poor recipe for successful investing.
In our Part I example, I chose the JPMorgan U.S. Large Cap Core Plus Fund (JLPSX). We compared the top holding percentages to three other U.S. Large Cap Blended Funds: BlackRock Advantage Large Cap Core Institutional (MALRX); Goldman Sachs US Equity Insights A (GSSQX); Janus Henderson Growth And Income A (JDNAX).
The top 10 holdings for all four funds ranged from 20-30% of total fund assets.
Now we want to look for the level of overlap between the funds.
All 4 funds have Microsoft and Apple in their top 10 holdings. Not significant, but still a doubling up of 2 core holdings.
If we look a little deeper to the top 20 holdings, we see that 3 funds all share stocks such as Google, Texas Instruments, McDonald’s, Amazon, and Facebook. Roughly half the top 20 holdings are the same from fund to fund. Not surprising given the funds are from the same style.
When investing in multiple funds within the same investment category, you will often see duplication of holdings.
Funds of Similar Styles May Have Similar Returns
Also, with similar exposures, I would expect that the gross fund returns for these funds to be close.
In fact, as at May 8, 2018, their annualized total returns for the prior 3, 5, and 10 years were respectively:
JLPSX: 8.98%, 12.50%, 9.57%;
MALRX: 10.50%, 12.61%, 8.29%:
GSSQX: 10.34%; 13.11%, 8.73%:
JDNAX: 10.92%, 12.21%, 7.89%.
The difference in performance is likely due to: some differences in investment selection; the timing of purchases and sales of holdings; management fees and the total expense ratios; etc. But surprisingly, or not, very little difference in annualized returns over 3, 5, and 10 years.
Not to get ahead of ourselves, but let me add the S&P 500 return to the above data. The S&P 500 is a suitable benchmark for the above funds. However, it does not have experts buying hot stocks and selling dogs. It just sits there passively. One might expect this poor unattended benchmark to pale in performance versus the expert active managers. Or not.
S&P 500: 10.35%, 12.66%, 9.02%.
Professional stock picker or not, it is very hard to beat the passive index benchmark over time. But we shall save a favourite topic of mine, the active versus passive management debate, for later.
For now, just remember that there are often big similarities between funds in the same investment category. If you want to diversify in funds, make sure that you are not buying essentially the same fund under a different name.
Another Issue with Speciality Funds
This is also a problem with specialized investment styles, geographic regions, niche investments, etc.
The smaller the number of investment options, the more likely that funds within the same style will have common holdings.
If you intend to acquire specialized mutual funds, I suggest you limit your investment to one fund in each category.
While you may not always end up with the top performing fund, you will avoid potentially overlapping your underlying investments and paying extra fees.
Be Careful Across Styles As Well
Some investments seem to crop up in many different investment categories.
Apple is always a culprit. I have seen it in growth funds, value funds, tech funds, etc. The popular stocks often find their way into many fund holdings. In Canada, the major banks seem to be everywhere.
Just because you own two mutual funds of differing style, you may end up with some similarities in holdings.
For example, in Canada you might own a Canadian Large Cap Blended fund, the PH&N Canadian Equity Value D. You would like some diversity. Perhaps something with smaller companies, the Mackenzie Canadian All Cap Value D. To counter the value funds, we will purchase a growth fund, the IA Clarington Canadian Growth Class A. And let us add in some dividend income in the Meritas Monthly Dividend And Income Series F. A nice mix of investment styles.
Four “different” funds. Yet the major Canadian banks appear in all. Within the top 15 holdings, all the above funds own significant amounts of Royal Bank, Canadian Imperial, Toronto Dominion, Nova Scotia, and Montreal. Only Meritas does not include Canadian Imperial or Montreal in its top 15.
In a relatively small market like Canada, the significant companies often are held by many funds. Regardless of their being labeled value, growth, equity, or dividend.
Always make sure you check to avoid getting too much exposure to any one holding and that you are attaining the diversification you desire. Never simply rely on the fund name or description of its investment style. Dig deeper into the actual fund portfolio holdings.
by WWM | May 2, 2018 | Mutual Funds
Investors like mutual funds because they are a simple way to diversify one’s portfolio on a cost-effective basis.
When investing in funds, individuals need to ensure that they are truly diversifying. Often investors think they are diversifying, but in actuality they are not doing an effective job.
Today, we will take a look at ways to ensure you properly diversify. Our focus will be portfolio concentration.
Understanding and properly utilizing diversification is crucial for investing success. For a refresher, please review my earlier posts: “Introduction to Diversification”; “Diversification and Asset Correlations”; “Asset Correlations in Action”; “A Little More on Diversification”.
Intra-Fund Portfolio Analysis
When analyzing a fund for investment, consider the diversification within the specific fund.
To do that, review the fund’s investment portfolio.
Concentration of Key Holdings
Your focus should be on the largest holdings as a percentage of the total portfolio.
I like to look at the top 10 holdings and often even the top 3 or 5 investments as well.
You want to ensure that a small number of investments do not have too great an influence on the fund’s total performance. If this occurs, the benefits of diversification may be reduced.
There is no magic number as to what proportion should make up the top 3, 10, or 20 holdings. The right mix will differ depending on the type of fund and the views of each investor.
For example, JPMorgan U.S. Large Cap Core Plus Fund (JLPSX) is a U.S. equity fund that invests in U.S. domestic companies. The fund owns shares in 162 different companies. Pretty diverse, no?
But what if I tell you its top 3 holdings account for 10.69% of fund assets? Its top 10 holdings account for 28.26%? Some might view these percentages as a little high given the breadth of available investments. They may not see it as so diverse a fund. Others may not. In fact, probably a normal distribution for many large funds.
If we compare that with the Fidelity® China Region Fund (FHKCX) equity fund, we see less diversification. The China fund owns 80 companies, so sounds diverse. But its top 3 holdings make up 25.69% of the fund’s assets and its top 10 holdings are 39.97%.
Even though a fund may hold 80 or 100 different companies, it may be much less diverse than one expects.
Be Cautious with Specialized Funds
The more specialized an investment style, the less possible investments exist for inclusion in a fund’s portfolio. The less available investments, the greater potential for poor diversification.
The investment universe for JPMorgan U.S. Large Cap Core Plus Fund should be significantly larger than for Fidelity® China Region Fund. As such, I would expect more diversification within the JP Morgan fund relative to Fidelity.
When analyzing niche funds, it is important to take this into consideration.
Another diversification consideration for many specialized funds is that there will be a high degree of correlation between the assets held in the fund.
For example, consider the Oppenheimer Gold & Special Minerals Fund Class I (OGMIX). 91 holdings, so nice diversification. At least in number of companies. However, the top 3 holdings make up 20.35% of the fund assets. And the top 10 comprise 45.88%. Not as diverse as the 91 holdings may indicate.
Further, as the name states, this fund is exposed to a very narrow niche of assets. The JP Morgan fund has the largest investment universe of the three funds. It diversifies among many sectors and its main emphasis is in Technology (19.5%), Financial Services (18.12%), and Industrials (14.17%). The top three sectors only account for 51.79% of the entire fund. Lots of other sectors are well represented.
The Fidelity fund is narrower in focus, reflecting less opportunities in China. Its main sectors are Technology (41.06%), Consumer Cyclical (16.69%), and Financial Services (12.62%). These three make up 70.37%. Much less room for other sectors to impact. And the sole focus of the Oppenheimer fund is Basic Materials (99.82%).
Comparison to Peers and Benchmarks
As with all other analysis, compare a fund’s diversification against its peers and components of its benchmark.
For example, let us use the JPMorgan U.S. Large Cap Core Plus Fund from above. The fund holds 162 different companies. Its top 3 holdings make up 10.69% of fund assets. Its top 10, 28.26%.
Other U.S. Large Cap Blended Funds include the BlackRock Advantage Large Cap Core Institutional (MALRX), Goldman Sachs US Equity Insights A (GSSQX), and Janus Henderson Growth And Income A (JDNAX). Also, according to the JPMorgan profile, suitable benchmarks may be the Russell 1000 or Standard & Poors (S&P) 500 indices.
Just looking at each fund’s holdings, we see the following for their top 3 and top 10 percentages of total holdings: BlackRock at 8.16%, 21.24%; Goldman Sachs at 6.8%, 19.48%; Janus at 11.82%, 32.11%. Some differences, but JPMorgan is within the grouping of peers.
If we compare to the Russell 1000 or S&P 500 indices, the differences are more pronounced. The Russell 1000 index top 3 and top 10 holdings make up 8.45% and 18.13% respectively. The S&P 500 are 9.48% and 20.24%. JPMorgan is more top heavy in holdings than the benchmarks. Probably not a cause for concern, but there is a difference.
Again, this is not surprising. The benchmark contains all its holdings, both strong and weak. One expects that the fund manager would avoid the obvious weak components of the benchmark index and over-allocate to components that the manager expects to outperform. Hence, you would expect a greater concentration in certain holdings.
Of course, whether the fund manager is correct in his allocations is a topic for another day. And the greater the variance from the benchmark, the more questions that should be asked.
As we are getting a little long on the topic, I will break this subject into two parts. Please tune in next week for a look at Inter-Fund Portfolio Analysis.
by WWM | Apr 25, 2018 | Mutual Funds
Analyzing mutual fund performance may seem straightforward.
Look at a fund’s results for different time periods. Then compare returns against peers and relevant benchmarks. And away you go. Unfortunately, relative performance can be distorted through survivorship bias.
Today we will look at this issue and its close relation, creation bias.
Survivorship Bias
Survivorship bias makes performance figures for a fund family (or investment style) appear better than they really are.
The bias occurs when under-performing funds are liquidated or merged into other funds. Over time, certain funds (and their historically poor performance figures) disappear from the fund family charts. With the weak funds no longer on the books, the average performance for the fund family and the investment category improves.
Think of a class of 10 students with the following averages: 96%, 90%, 88%, 80%, 74%, 70%, 68%, 22%, 12%, 10%. Your average is the 68%.
The simple mean average for the class is 61%. You are quite pleased to be in the top half.
However, the bottom three students drop the class after mid-terms. Their marks are removed from the class average. A new class average is calculated at 81%. You have now moved from the top half to the bottom. Congratulations!
This is the effect of survivorship bias. True performance gets skewed upwards when poor performers are eliminated from the calculations. The mediocre or weaker performers look even worse in the new comparison.
You can see that you need to be cognizant of both effects when analyzing mutual funds.
When assessing a fund family or investment style, poor performers may disappear causing the family or style to have better performance than they really had.
When analyzing funds that rank in the middle or lower half of an investment style, bear in mind that there may have been weaker performers in the group. But they have been discarded making the mediocre funds appear even worse.
Survivorship Bias Frequency
Liquidating weak funds is a common occurrence in the mutual fund industry.
While the impact of survivorship bias may not be rampant, it occurs frequently enough to be a concern for investors.
It can be an intentional act by a fund family to improve performance data or possibly an unintended consequence due to natural changes in individual funds.
Most mutual funds want to attract new investors and increase assets under management. That is how a mutual fund makes its profits.
If performance of a fund is poor over time, it will have difficulty attracting new capital. Further, poor individual fund performance may reflect negatively on the fund family which manages the fund.
It may be in the fund family’s best interest to shut down the under-performing fund or consolidate it into another fund, making its historic results vanish.
Acceptable treatment in many jurisdictions, but not what I consider an overly ethical practice.
Then there are the funds that disappear due to more natural occurrences.
For example, say there is an investment style for which only 4 mutual funds exist. The 1, 5, and 10 year returns for each respectively are: A: 27%, 25%, 22%; B: 32%, 30%, 19%%; C: 18%, 21%, 24%; D: -12%, -8%, -4%.
Assuming all other analytical considerations (e.g., manager tenure, expense ratios, etc.) are similar, would new investors ever consider mutual fund D? Probably not.
And I expect that existing shareholders in fund D would become frustrated with D’s performance and begin to shift their money from D to the other funds.
Over time, unless D improves its relative performance, its asset base will fall significantly. Part of the problem is the negative returns erode fund assets. Second, as shareholder redemptions increase, the fund must convert higher portions of its investments into cash to pay exiting investors. This should restrict fund manager investment tactics and further impair future performance. Finally, as assets leave, expense ratios will rise which further hurts results.
The cycle will continue until results improve and the money outflow ceases. Or, at some point in time, all the assets of the fund will be gone. At that point, the fund will be terminated.
Creation Bias
You may also come across the term creation bias.
Creation bias is a type of survivorship bias.
Fund families often provide seed capital to fund managers to create new funds. These funds are run privately for a short period (e.g. two years).
Any successful funds are made available to the investing public, while the poorly performing funds are liquidated and their results “disappear.”
Assessing Survivorship Bias
This is often difficult to assess in a fund as reporting requirements are not strong in this area.
Some funds do disclose this information, so check the fine print on their websites or ask them about how they report results from discontinued funds.
The best way to avoid these two biases is to focus on funds with superior long-term (i.e. 10 year) performance. That allows you to assess a specific fund’s performance on its own merits and not simply short-term results that may look good in comparison to other funds simply because the poor performing competition has disappeared from the charts.
by WWM | Apr 18, 2018 | Mutual Funds
After evaluating a mutual fund’s relative performance, a review of fund management should be completed.
Why?
One, it is important to know who is choosing the investments within the fund.
Two, the fees paid to management are a significant percentage of total operating expenses.
If you are paying a lot of money for active management, you had better get good value.
In assessing fund management, here are a few things to check out.
Manager Performance
Obviously how a fund performs is key to in assessing management.
As it is fund management that makes the investment decisions, you can use the guidelines from Mutual Funds: Performance and Mutual Funds: Performance is Relative to help assess fund management’s performance.
In gauging manager effectiveness it is crucial to compare a fund’s managers to their peers and appropriate benchmarks.
How do other managers perform on the same playing field? That is: choosing from among the same possible investment universe; following the same investment style; operating in the same economic and market conditions.
Equally important is to assess management performance against no active management decision-making (i.e., passive investing). Does the money shareholders pay in management fees generate a positive return versus simply investing in a non-managed index fund? In investment jargon, does the active manager produce “alpha”?
This is the important active versus passive management debate that we will discuss in an upcoming post.
Manager Tenure
Maybe you are considering investing in Alpha US Large-Cap Equity Fund (Alpha).
From your research, its 5 and 10 year performance is extremely high relative to its peers and benchmarks. You are a little concerned about relative underperformance over the 1 and 3 year return periods, but you believe the long-term results make it a worthy fund for your money.
Perhaps.
But what if you learn the key fund managers left Alpha 4 years ago and were replaced by a new management team?
That may explain why the fund’s relative performance slipped in recent years. Maybe the investment tactics employed by the new managers are inferior to the previous ones.
Based on Morningstar data, the average fund manager stays approximately 4.5 years at his fund. That means there is a strong probability that fund management will change while you own a specific mutual fund.
It also means that you will be analyzing funds’s long-term performance that is not the result of investment decisions made by the current managers.
When assessing a fund, find out how long the current management team has been in place. If they have only been running the fund for a few years, they should not get credit for the performance of the previous team. Conversely, they should also not be blamed for poor results from now departed managers.
New Fund Managers
New fund management may be a positive or a negative.
If new managers were brought in to replace under-performers, then fund results may improve. That is good for investors.
If new managers are replacing successful ones who have left for greener pastures, then it might not be a good thing.
For new fund managers that may not have long-term results in their current fund, you need to look at their previous positions to assess the likelihood of success in their new roles.
In our example, Alpha is an equity fund investing in US large-cap stocks.
First, I would expect to see that the fund managers have experience in this investment category. If their previous management was in bond or money market funds, I would question their future success in an equity fund.
If they do have experience with equity funds, how close is it to the investment style of the fund you are considering? Analyzing US large-cap stocks is somewhat different than researching European small-cap companies.
Ideally the fit between their past experience and current jobs should be close.
Second, a new manager should have demonstrated success in his previous funds.
If a fund manager has no positive middle to long-term track record, I would be leery of letting him manage my money.
Old Fund Managers
Consider why a fund manager leaves a fund.
Did she move to a larger fund with more career potential? That may indicate that there are no problems with the fund. Simply that it was a good career move for the manager.
Or perhaps there was a problem with the current fund and it was like the proverbial rats leaving a sinking ship.
Why someone leaves is a factor and can indicate potential future performance issues.
For example, maybe the fund is experiencing significant shareholder redemptions. This would require the fund to liquidate some of its investments to have cash to pay out investors. This may impair a manager’s investment strategy and create future performance issues. With limitations on investing strategy (due to the need to maintain cash reserves for redemptions), a fund manager may feel constrained and leave for another fund with more freedom.
Another consideration with departing managers is their star power. In the past, funds promoted their star managers and used them to attract investors. If a celebrity manager leaves, will that cause an increase in shareholder redemptions?
Bear Market Managers
During bull markets (when the asset class is going through a general increase in value), it may be difficult not to make money. Even mediocre managers can attain strong performance.
The test of a manager’s skill is when the market is stagnate, or during bear markets (when the asset class, as a whole, is decreasing in value).
If you can determine how your manager performs during periods of both good and bad economic times, you may get a better feel for his expertise.
A common problem is that many fund managers are relatively young. As such, they may not have experienced multiple bull, bear, or flat markets. So it may be difficult to assess this in a fund manager.
Index Huggers
If you buy an actively managed fund, you pay a significant amount each year for fund management. Make sure that it is actively managed.
Index huggers (a.k.a. closet or pseudo trackers) are active managers that essentially just try to re-create the index used as their benchmark.
Fine if you are buying an index fund with a tiny management fee. Not fine if you are paying for active management, yet actually getting an index fund.
This can be a real problem for investors.
The WM Company, a Scottish based market research firm, analyzed fund data between 1980 and 2000. The study found that 74% of actively managed funds deviated less than 6% in their holdings from their benchmark index. That means that if an equity benchmark had 100 stocks in it, 74% of the mutual funds reviewed would have at least 94 of the same companies. And of that 74%, a full 40% of the funds had deviations less than or equal to 3%.
Why pay a management fee to someone who barely differs from the benchmark holdings?
To monitor for index hugging, you can review a fund’s holdings versus the benchmark investments. If they are highly alike, there may be an issue.
You can also consider what added value, if any, the actively managed fund provides over an index fund (i.e., a passive fund that merely tracks the benchmark index). If you do not see extra value, do not pay for the active management.
Management Teams
It should be noted that many mutual funds have moved to a management team concept rather than promoting single or co-managers. There are a few reasons for this shift.
One, while celebrity managers can attract new investors, they can also hold funds hostage in compensation demands. The star managers know that if they leave a fund, many shareholders will come with them. This gives the star leverage over the fund. By emphasizing a team approach over one celebrity manager, the leverage diminishes.
Two, team management promotes a consistent investment approach. With an average tenure of 4.5 years per manager, there is frequent staff turnover. A team allows for better internal consistency which should lead to better predictability of future performance.
Three, as with internal consistency, a team approach allows one to attribute long-term results to current management. The current managers may not all have been in place for the prior 5 or 10 years, but the team philosophy and strategies should be comparable between all periods.
For these reasons, I tend to prefer a team approach over single or co-managers.
Fund Manager Ownership
Funds may disclose the amount of personal money their managers have invested in the fund.
Some people believe that the greater a manager’s own capital is invested in the fund, the more they will be focused on fund performance. If the manager has no personal interest in the fund, they may have less focus.
While I can understand the argument, I give this little weight in my analysis.
Fund managers are professionals and should manage the fund in the same manner whether or not they have a significant personal stake in the fund. Also, their remuneration and opportunities for career advancement are tied to their results. To me, that is far more important to their long-term wealth than whether they invest in the fund themselves.
by WWM | Apr 11, 2018 | Mutual Funds
Investment returns are difficult to assess in isolation.
What does it mean if an asset has an annual return of 10%? Is it good, bad, or average?
To answer that, results must always be placed in context to be of any informative value.
That brings us to relative performance. We looked at this concept a while back in Assessing Investment Returns.
For numbers to make sense, they always need to be compared to something relevant.
Historic Performance
Depending on the jurisdiction, funds may be required to present performance data for multiple periods. For example: year-to-date; 1 year; 3 years; 5 years; 10 years; since inception.
Do not be mesmerized by year-to-date or the latest one year returns. Anybody can experience success in the short-run.
Luck can play a big role. Also, management trickery can be used to make current year returns look good. We will look at common fund manipulations later.
Of course, luck and manipulation can go both ways. They can also hurt results.
When reviewing, you must go back farther in time than one year returns. The longer the return data, the less chance that luck or portfolio manipulations will distort true performance.
To illustrate throughout this post, we will use a fictional mutual fund, ABC Canadian Equity Small-Cap Fund (ABC). Let us assume ABC had returns of 12% for 1 year, 10% annually over 3 years, and 11% annually over 5 years.
In comparing historic results, that suggests a consistency in fund returns. Consistency tends to be useful, though right now we do not know if those level of returns are good or bad. But it is a start.
However, if ABC returned 45% over 1 year, but still 10% annually over 3 years and 11% annually over 5 years, it suggests potential issues. This is a large variability of returns between years. Not to mention that the 1 year results may skew the 3 and 5 year data.
You need to determine why there was this volatility. There could be many reasons for the high variance. Perhaps performance reflected changes in the economy or markets as a whole. It may suggest a modification in investment tactics or a change in fund management. Perhaps the fund moved to increase its portfolio risk over previous periods.
When there is a large change in returns, you need to determine why. There might be ramifications for future results.
Bear in mind that past performance is no guarantee of future returns.
Past performance may provide clues as to future results. But, on its own, it is no guarantee of continued success.
Risk-Adjusted Returns
In assessing fund returns, compare performance against the level of risk within the fund.
You can compare the fund performance against zero return, the rate of inflation, or the so-called risk-free rate of return (that is, the return on an investment that has no risk).
I think most of us can agree that it is important for investments to provide positive returns. More difficult is agreeing how much above that base level – 0% nominal or real rate or the risk-free rate of return – the excess return should be.
One tool is to compare the investment risk for the category of your fund to other asset classes or investment styles with similar risk-return profiles. Or to adjust your return expectations for different risk levels.
For example, I would expect over the mid to long-term, riskier equity funds should outperform money market funds or other low risk investments such as term deposits or treasury bills. Remember that as risk increases, so should the expected returns.
A fund of US government bonds should have less risk than a fund composed of bonds from developing countries or a fund with bonds from distressed companies. Because of the greater risk, I would expect the funds from the developing countries or distressed companies to have higher long-term returns than a US government bond fund. But higher short term volatility as well.
In general, the riskier the asset, the higher the expected return should. But what the exact risk premium should be is up to the individual investor.
ABC earned 11% annually over 5 years. Perhaps very low risk money market funds generated 3% annually over the same 5 years. For some investors the trade-off between equity risk and expected returns is warranted. Other investors will prefer the safety of the money market funds, rather than the potential extra return from the equity. Other investors may desire riskier assets such as venture capital to seek out even greater returns.
Comparing fund performance against assets of higher or lower risk gives some comfort as to the expected risk-return trade-off.
This has some use for analytical purposes, but it does not assist in choosing a specific fund to invest in. Not to mention that assessing risk premiums between different asset classes or subclasses can be difficult. A bit of an apples to oranges comparison.
What we want is apples to apples. For that, you need to look at a fund’s direct competition.
Peer Group Returns
In comparing funds for possible investment, historic returns within the fund alone do not mean much.
What does it really tell me to know in isolation that ABC had a 1 year return of 12% and a 5 year annual return of 11%?
Not a lot.
We can compare the risk-return of ABC to other assets. Perhaps the 5 year annual return for U.S. large cap stocks averaged 9%. Is that good relative to ABC’s performance? Some investors may say yes, others no. Some have no idea. Hard to tell because U.S. large cap stocks differ in many ways from ABC’s small cap Canadian holdings. Apples to oranges.
However, a fund’s peer group is made up of the funds with the same investment style. Apples to apples. From our example, all Canadian equity small-cap funds would be the appropriate peer group for ABC. Now we can start better assessing ABC’s performance.
If the average Canadian equity small-cap mutual fund had a 5 year 8% annual return, 11% from ABC appears strong.
Do not stop there though. Averages can often be misleading.
You should also look at the relative ranking of ABC within its peer group.
Perhaps 10% of the peer group had 5 year annual returns exceeding 20%. Another 20% had returns greater than 15%, and another 20% had returns higher than 12%.
ABC had better 5 year annual returns than the average for the entire peer group. But when looking within the peer group, at least half of the funds outperformed ABC over the 5 year period. Seeing that, I might want to consider the funds that exceeded 20% return over ABC.
When determining which funds to invest in, comparison to a fund’s peers is very important.
And like with historic returns, the longer the comparative periods, the better the analysis.
Benchmark Returns
Another excellent way to assess performance is to compare it against a benchmark return.
Benchmarks can be anything. However, in practice, broad indices are used that try to most closely reflect the investment style of the fund.
An appropriate benchmark for ABC might be the MSCI Canada Small Cap index. The MSCI index tracks smaller capitalized Canadian companies. This is preferable to the better known S&P/TSX Composite Index. Why? Because the TSX Composite Index is weighted by market capitalization, so it has a large-cap bias.
To the extent possible, always try to compare apples to apples with benchmarks. This is especially true for the many investors who compare their portfolios to the Dow Jones Industrial Average. A very popular index in the media, but it only tracks 30 extremely large U.S. listed companies. Most investors have portfolios of a much different composition.
For many funds, you do not need to create your own benchmark. The fund itself determines a benchmark for comparison and discloses the benchmark to investors.
Always check to ensure that a fund’s benchmark is truly representative of the fund’s investment style. In our example, comparing the performance of ABC to 90 day U.S. Treasury Bills or 30 year Euro bonds makes little sense.
There may also be a standard benchmark for the peer group within which your fund sits. That way it is easy to compare funds within a specific peer group to each other and the same benchmark.
A major problem with comparing fund performance to an index is that the fund has operating expenses. An index does not. The greater a fund’s total expense ratio, the larger the performance deficit versus the benchmark. As a result, funds start at an immediate disadvantage when trying to beat their benchmarks.
Consider an index fund that mirrors the S&P 500. To the extent that it can duplicate the index, the gross performance of the fund should match the performance of the S&P 500. Perhaps the gross returns for both were 10% last year. But the fund also has a 2.0% total expense ratio. So, on a net return basis, the index fund under-performed the benchmark by 20% (10% for the S&P 500 versus 8% net return for the index fund).
Another thing to watch with benchmarks is that the fund sticks with its chosen benchmark. Should the fund change its investment style, it may be appropriate to modify its benchmark. But if it changes its benchmark simply to hide under-performance or in trying to make itself look better, be wary.
Summary
Past performance is not an indication of future investment success.
It may show a consistency of performance, especially if you look at longer term results. And it may indicate potential problems or changes within a fund.
While historic returns have some value, you should compare a fund’s returns against other asset classes of differing risk. You want to ensure that the risk premium on your asset is reasonable given other potential investments.
Even more important, always compare a fund’s performance against its peers and relevant benchmarks.
In assessing peers, look at both absolute returns and the fund’s ranking within the peer group.
In reviewing against a benchmark, ensure the chosen benchmark is appropriate for the fund’s investment style.