Evaluating
Your Money Manager's
Investment Performance
Dave Voss
Ernst & Young LLP
If
you use professional money management, the close of the tumultuous
and tragic year of 2001 affords an opportunity to pause and evaluate
the performance of your manager. Has your money manager performed
as expected? If not, why not? In times of economic uncertainty
and troubled markets, evaluating the performance of your money
manager is a more important task than ever.
Fortunately, there
have been many recent advances in the art and science of performance
evaluation. Investment consultants have at their disposal increasingly
sophisticated statistical techniques and analytical tools. These
tools can be used to determine not only the rate-of-return that
occurred over the time period, but also to determine the factors
that drove portfolio performance.
The questions to be
asked in evaluating performance include: How did the manager
perform compared to a passive benchmark or index? What risk did
the manager take to achieve a particular return? Were the securities
chosen by the manager consistent with his or her mandate in terms
of investment style? Did the manager deliver sufficient value-added
or additional return to justify the fee for active management?
What were the factors that drove portfolio performance?
We should say here
that there are many benefits to active portfolio management as
compared to investing in a passively managed portfolio such as
an index mutual fund. Actively managed portfolios can be fine-tuned
to correspond with an investor's overall needs and objectives.
And perhaps most importantly, active portfolio management can
help preserve wealth in down markets. Index funds, by definition,
are the market and their performance will mirror the performance
of the market in both up and down markets.
However, the benefits
of active management come at a price. Money managers charge fees
for active management that are higher than the fees incurred
for a passively managed portfolio, such as an index mutual fund.
Thus, one of the goals of performance evaluation is to determine
if the manager delivered sufficient value or excess returns to
justify the fee for active management. Here are some of the tools
and techniques that can be used to evaluate your manager's performance.
Passive Benchmarks
The
simplest tool for evaluating performance is to compare the return
of the manager to the return of a passive benchmark. It is commonplace,
for example, for managers of domestic equity portfolios to see
their performance compared to that of the Standard & Poor's
500 Index. Such comparisons can be useful as a rough gauge of
a manager's results.
However, there are
shortcomings to using standard passive benchmarks. They are valid
only to the extent that the universe of stocks from which the
manager constructs your portfolio and the stocks included in
the passive benchmark index have similar characteristics.
Thus, the performance of a manager of small-capitalization stocks should not be compared to the performance of the S&P 500, which is a large-cap stock index. Instead, a small-cap index such as the Russell 2000 would be more appropriate. Hundreds of passive benchmarks are available, reflecting not only market capitalization levels but also investment styles, such as growth and value. The closer the benchmark fits the style of the manager who is being evaluated, the more useful it becomes for comparison purposes. Take the example of a manager who purchases small-cap growth stocks. While the Russell 2000, a small-cap domestic stock index, could be used as a performance benchmark for such a manager, a more style-specific, small-cap growth benchmark such as the Russell 2000 Growth Index would be more appropriate.
Blended Style Benchmarks
In
some instances, using an off-the-shelf index to evaluate a manager's
performance will be inappropriate. One way active managers can
deliver excess returns is to not confine themselves to a particular
segment of the market, but rather, cast their nets more widely.
For example, even though a particular manager may devote 50%
of the value of his or her portfolio to large-cap value stocks,
the remainder might be invested 20% in mid-cap value stocks and
30% in large-cap growth stocks. Let's assume that this manager's
return for the fourth quarter of 2001 was 8.0%. If this return
were compared to the performance of the large-cap Russell Top
200 Value Index, which returned 5.52% for the period, he would
have beaten it easily.
Why? Because of the
portfolio's exposure to large-cap growth stocks and mid-cap value
stocks, both of which outperformed large-cap value stocks in
the fourth quarter. A more appropriate benchmark would be a custom
benchmark with a weighted return that consisted of 50% of the
return of the Russell Top 200 Value Index, 20% of the return
of the Russell Mid-Cap Value Index and 30% of the return of the
Russell Top 2000 Growth Index. The return of that custom benchmark
turns out to be 9.02%, a much more accurate number in evaluating
the performance of this manager.
Adjusting Return To Reflect Risk
Much like the world of sports, the world of investments is awash with scores. But the winners who get the attention at the end of the quarter are not the touchdown leaders or the home run champions. Rather, they are the investment managers with the highest absolute returns. Unlike sports fans, however, investors need to be able to evaluate how much risk was assumed in order to deliver those winning results.
Which Manager Had Superior Returns?
Manager
A with a return of 10% or Manager B with a return of 9%? An investment
consultant would probably first assess the risk assumed by each
manager before responding to the question. A number of statistics
have been developed to measure portfolio return adjusted for
risk. Alpha, for example, is a statistic that gauges the amount
of return in excess of what would be expected given the riskiness
of a portfolio.
A positive alpha statistic
indicates that the money manager is delivering a higher return
than would be expected given the portfolio's risk. A manager
whose absolute return beats the index but with a negative alpha
statistic is actually under performing the index on a risk-adjusted
basis. On the other hand, a manager who under performs the index
on an absolute basis, but has a positive alpha statistic is actually
out performing the index on a risk-adjusted basis.
Universe Or Peer Rankings
It
makes sense to compare the returns of a manager to others with
the same investment style. But such peer group rankings have
limitations that should be recognized. As noted above, if adjustments
have not been made for style differentiations or for the relative
riskiness of the portfolios in question, the usefulness of such
comparisons is limited. Managers whose absolute performance ranks
highly when compared to their peers often are among those managers
who have taken the highest amount of risk. Consequently, any
peer group analysis of a manager's performance should also include
a peer group ranking of the manager's risk adjusted return and
alpha.
And peer group rankings
over time suffer from a phenomenon called survivor bias. Managers
with particularly poor performance records intentionally fail
to report their returns to the firms that maintain the peer universes
or the managers go out of business eventually. As a result, the
historical performance of the better managers who stay in business
and remain in the peer universe overstates the actual performance
of the peer group in past periods.
Performance Attribution
Performance
attribution attempts to identify and quantify the contribution
that the various facets of active portfolio management made to
overall portfolio performance. Among other things, managers can
add value by both sector selection and superior security selection.
Managers can add value by over weighting the portfolio in those
industry sectors that perform better than the overall performance
of the benchmark. (By over weighting, we mean that the weight
or percentage of the total value of the portfolio that the manager
has invested in a particular sector is greater than the sector
weighting of the benchmark index.) For example, if the Health
Care sector had a return of 6% for the time period and the overall
index had a return of 4% for the same time period, the manager
would have added value by over weighting the Health Care sector.
Conversely, a manager can also add value by under weighting sectors
that perform worse than the overall performance of the benchmark.
Mangers are ultimately judged on their security selection skills.
Managers add value by selecting securities within an industry
sector that perform better than the performance of the overall
industry sector. For example, if the performance of the Technology
sector of a stock index was 5% for the quarter, but the performance
of an equity manager's Technology stock selections was 3%, the
manager added value by her Technology stock selections.
Interestingly, managers
can often be poor sector selectors but superior stock selectors,
and vice versa. A manager will achieve superior returns when
both sector selection and stock selection make positive contributions
to performance. Investment consultants can help you gain a better
understanding of the factors that drove your investment performance
through their performance attribution analysis.
Editor's Note: Dave
Voss is a partner with Ernst & Young LLP. He also serves
as editor of Ernst & Young's Financial Planning Reporter.
The above article is intended to provide general information
only. It is not intended to serve as investing or tax advice.
Readers are encouraged to consult with professional advisors
for advice concerning specific matters before implementing and
investment or tax strategies.
