Since my colleague Jake Moeller, Lipper’s Head of Research for the U.K. & Ireland, wrote in his last Monday Morning Memo about the reasons an investor might sell a fund, I thought it would be worthwhile to write about the initial fund selection. To find a suitable fund it is necessary that the purpose for which the fund is being bought is clearly defined and that investors know their preferred performance profile.
Once the decision to invest in a given asset type or sector has been made, investors have to find the fund(s) that best suit best their needs. Since in some sectors there are hundreds of funds available to investors, it is necessary to narrow the investment universe by using a quantitative research process to evaluate fund performance.
To evaluate the performance of a mutual fund an investor must compare the performance of the fund to the performance of the appropriate market and other funds with the same or similar investment objectives. This means an investor needs to compare apples to apples–or even better, green apples with green apples and red apples with red ones–to employ a proper quantitative screening process. Even though this sounds very simple, it is a rather difficult task, since investors need to take into account that funds with the same investment objective might use different techniques (such as hedging strategies) to achieve their goals. To find a proper classification becomes even harder, when one is looking at alternative UCITS or multi-asset funds. These funds might have the same investment objective but employ totally different sources to generate returns, meaning that the funds might contain totally different risk factors. In this regard, it is important that the investor not only looks at the asset type and investment objective when he tries to classify a fund, he also needs to look at the performance and risk drivers within the portfolio. The fund prospectus is only a starting point for the fund classification, since the prospectus gives the investor only a general idea of what the fund manager can or can’t do to achieve particular goals.
The second step must be to view a detailed presentation, since that is the only way to understand what the fund manager is doing, especially in regard to rather complex products. In addition, one needs to monitor the holdings of the fund to see if there is any style drift and/or change of investment focus within the portfolio.
Even though past performance is no guarantee of future performance, past performance is the only source telling an investor how a fund has behaved in different market environments. Past performance is the only source for evaluating the risk/return profile of a fund. It is necessary that the investor use a period with enough data points to show statistically relevant results. A number of investors prefer monthly data for a three- to five-year period, i.e., 36 to 60 data points, to evaluate the performance of a fund. Even though it seems this number of data points is rather small, this period might be more relevant to evaluate the performance of a fund than longer periods; the fund manager or parts of the process might change during longer periods, which would falsify the results of the quantitative research.
To evaluate the performance of a fund in comparison to the underlying market and its peers, it is necessary to analyze a number of non-overlapping periods in both bull and bear markets. Only in this way can the length and the magnitude of an out- or underperformance in the given market environment be measured to gain an understanding of the performance profile of a fund during different phases of a market cycle.
In addition to the “plain-vanilla” evaluation of performance, some investors also use risk-adjusted ratios such as the information or Sharpe ratio to assess a fund.
Pitfalls of Ratios
If an investor uses risk-adjusted ratios in addition to plain-vanilla performance measures, the investor needs to understand in detail the formula behind the ratio and to ensure that the employed ratio works in all market conditions. One example is the often-quoted Sharpe ratio. Professional investors know the weaknesses of this ratio in negative-performance environments and would rather use an alternative measure such as the Israelsen ratio to determine the risk-adjusted performance of a fund. Since the Sharpe ratio is often used by the media or on Internet platforms, private investors and their advisors are often unaware that they shouldn’t use the ratio in negative-performance environments.
Some investors try to take a shortcut in the quantitative research process by using quantitative fund ratings from independent rating providers, since these ratings are often available free of charge. But this is not the purpose of the ratings. Any quantitative rating is a measure that should give the investor a hint of which funds are the best under the constraints of the methodology used to evaluate the funds in a given peer group. The measures employed in the given methodology might or might not suit the needs of the investor. In this regard, an investor must have a detailed understanding of the measures used in any given fund rating in order to use the rating in a fund selection process, even as a supplement to an individual fund assessment process. From my point of view, a fund rating or even a fund award should be used along with other quantitative measures, but it should never be used as the only criterion to select a fund; normally, no fund-rating methodology completely meets the needs of an individual investor.
After the quantitative assessment of a given peer group the investor needs to verify the results and analyze the most suitable funds in more detail to find the fund that best suits a particular purpose. This second step in the fund research process is the qualitative research.
The qualitative research process begins with the fund prospectus, since the prospectus can give the investor detailed information on which derivatives or security lending strategies a fund manager can employ to enhance the performance of the fund. Because of the language used in the standard fund prospectus, it is often difficult to extract this information.
The next step in the process is to send a questionnaire, the so-called request for proposal (RFP), to the asset management company to gain more detailed insight into the wider fund management process. The questionnaire should not only contain questions on staff turnover, changes in the management style, or the management and research process, it might also contain questions on the company’s share- and stakeholder structure. One important point that should be covered in the questionnaire is the risk management process employed by the asset manager, since that process might be the key to achieving the risk targets of the fund and/or to keep the fund in line with the expected general risk profile. The RFP might also contain questions about the general policies of the asset manager, such as exercising shareholder voting rights, etc.
This approach also applies to investors who favor passive products, since the investor needs to understand in detail the methodology used to determine the index constituents and their weightings within the index, as well as the general policy of the fund with regard to the use of derivatives and security lending strategies.
To complete the qualitative assessment the investor needs to interview the fund manager. While the first contact should be in person, updates can be done over the phone. The first interview can be done at the investor’s office or as an onsite visit to the fund by the investor. Even though it is more convenient to have the fund manager go to the investor’s office, I personally prefer to make onsite visits, since they give the opportunity to speak to other key staff such as analysts and the risk manager to gain even more detailed insight on the management and research process and to validate the answers given in the RFP.
By the way, it can be great fun to ask the fund manager during a one-on-one interview the same questions as in the RFP, since the fund manager might give different answers to the same questions. With regard to a deeper understanding of what is going on in the portfolio, it is worthwhile to review the holdings of the fund and to challenge the fund manager with questions on holdings that do not look suitable for a particular investment approach.
Since the whole process is done to understand in detail what a fund manager is doing to outperform the market and his peers as well as to get an idea of when a fund is likely to out- or underperform a particular management approach, investors need to develop their own standards for quantitative and qualitative research. From my point of view, the quantitative and qualitative fund research goes hand in hand for fund selection, since neither one can answer all the questions on its own. But in conjunction the two approaches can deliver a very clear picture of whether a fund is suitable for a given investor. Investors looking at the same performance numbers might come to the same conclusion regarding the quantitative research, but since qualitative research is driven individually according to specific requirements, the results of this process can differ widely between investors.
The views expressed are the views of the author, not necessarily those of Thomson Reuters.