Most people are pleased if their pension fund has risen in value and upset if it’s gone down. However the fund management industry and investment consultants are more interested in ‘relative performance’ than absolute performance. That is, how the fund has performed compared with how other similar funds have performed.
For example, if the fund in question has risen by, say, 7% but in its peer group of similar funds the middle performing fund – or the benchmark index – increased by 9%, your 7% is shown to be a poor result. Even if you were pleased with 7% once you know what a fund of that type should have made you have cause to be disappointed. Questions should be asked of the fund manager or consultant so you can understand why it lagged behind its sector. What are they doing about that for the future?
Conversely if your fund went down by 7% but in its peer group the middle performing fund – or benchmark index – lost 9%, your fund performed better relative to its peers or its benchmark because it lost less.
This is one way that company pension managers and trustees monitor their fund managers and it is part of the decision making process when hiring or firing managers, or changing funds in the scheme’s fund range.
It is very frustrating when your fund has lost money and the investment manager or adviser says they have done well, but what they mean is relative to what similar funds have done over the same period.
There are a number of statistics used in fund management presentations and on fund fact sheets which if understood would help to explain why the funds are performing as they are, and how well the fund manager is contributing to good or bad performance. For a fund rising in value the fund manager may not be adding any of that value if it can be shown all the increase is coming from a rising market. If you were paying active management fees you would not have been receiving value for those fees and you may want to consider switching to a passive fund or identifying if the fund manager can make the improvements you need. This is the knowledge that can be gained by understanding some of the fund management ratios.
Here are four of the most useful:
The R-Squared is an indication of how closely correlated a fund is to a benchmark. Treated as a percentage it indicates what proportion of a fund’s movements can be attributed to those of the benchmark. Values for R-Squared range between 0 and 1, with 0 indicating no correlation at all, and 1 being a perfect match. Values upwards of 0.7 suggest that the fund’s behaviour is increasingly closely linked to its benchmark, whereas the relevance diminishes as R-Squared descends towards 0.5, and starts to disappear altogether below that.
R-Squared is a key ratio, in that other measures of a fund’s performance will have been calculated by reference to its benchmark so the weaker the R-Squared correlation, the more unsuitable the benchmark is, and the more unreliable these measures will be in assessing the fund.
Standard deviation is a statistical measurement which, when applied to an investment fund, expresses its volatility, or risk. It shows how widely a range of returns varied from the fund’s average return over a particular period. Low volatility reduces the risk of buying into an investment in the upper range of its deviation cycle, then seeing its value head towards the lower extreme. For example, if a fund had an average return of 5%, and its volatility was 15, this would mean that the range of its returns over the period had swung between plus 20% and minus 10%. Another fund with the same average return and 5% volatility would return between plus 10% and zero, but there would at least be no loss.
While volatility is specific to a fund’s particular mix of investments, and comparison to other portfolios is difficult, clearly, for those that offer similar returns, the lower-volatility funds are preferable. There is no point in taking on higher risk than necessary in order to achieve the same reward.
Information Ratio So called because it assesses the degree to which a manager uses skill and knowledge to enhance returns, this is a versatile and useful risk-adjusted measure of actively-managed fund performance. It is calculated by deducting the returns of the fund’s benchmark from the fund’s overall returns, then dividing the result by its Tracking Error (which is a measure of the volatility of those excess returns, see below). This gives us the value of extra risk taken by the fund manager’s decisions which have added to what the market would have delivered anyway.
The higher the Information Ratio the better. It is generally considered that a figure of 0.5 reflects a good performance, 0.75 very good, and 1.00 outstanding. This is particularly useful when comparing a group of funds with similar management styles and asset allocation policies.
Tracking Error This statistic measures the standard deviation of a fund’s excess returns over the returns of an index or benchmark portfolio. It can therefore be an indication of ‘riskiness’ in the manager’s investment style. A Tracking Error below 2 suggests a passive approach, with a close fit between the fund and its benchmark. At 3 and above the correlation is progressively looser: the manager will be deploying a more active investment style, and taking bigger positions relative to the benchmark’s composition.