Analyst Spotlight Archive

Analyst Spotlight: Benjamin King

"When Judging a Fund's Performance, Take a Step Back"

Quiz: The following table lists five different funds, together with the number of days in the first quarter of 2008 in which its return was higher, lower or even with that of the S&P 500. Which one performed best during the quarter?

Obviously, this is a trick question - it is impossible to determine the answer without any idea of the magnitudes of the outperformance and underperformance. The actual performance will be discussed later but it is an interesting exercise for investors in actively managed products to think about this. For instance, if you look at your holdings every night and compare the performance against the market, isn't it most satisfying to own Fund A, which beat the index almost two out of every three days, rather than any of the other choices? Alternatively, isn't there always some temptation to sell a fund like Fund E that only seems to beat the index occasionally?

The performance of the funds in question is listed below and it is immediately apparent that a fund's ability to beat the index on a daily basis has little to do with cumulative performance. In fact, the second best fund in terms of beating the index was actually the worst performer and the only fund to underperform the index. Also note that the only two funds not to lose money for investors both beat the index only slightly more than half of the time.

Clearly, no one allocates their portfolio using this sort of rationale but once you have chosen investments for your portfolio, these sorts of questions can seriously erode your investing discipline. If you allow yourself to continually think in terms of a series of daily performances rather than a longer time horizon, it is actually very easy to create unearned confidence in some investments and unearned negativity towards others. It is very difficult - and important - to overcome or at least acknowledge this challenge and continue to objectively monitor the investments in your portfolio with regard to the long-term goals of the portfolio.

The simplest solutions to this problem are to avoid checking returns on a daily basis and not to compare investments to the broad equity market index. However, given that many investors typically have a lot of time, money and pride tied to their portfolios, it is often difficult to avoid watching the markets and investments on a daily or almost daily basis. Nonetheless, taking a longer view of a fund's performance is usually the best course of action for most investors.

High Frequency Measurement can Clash with Expectations
Another problem with high frequency monitoring is that it can often mess with one's expectations for your investments. When you do your research and choose an investment, there is typically some expectation of how that investment will perform over time. It may be unstated and will vary from one investment to the next but if you do not expect that an investment will enhance returns or reduce risk, you will most likely not have it in your portfolio.

But on a day-to-day basis, what is your expectation of how your investments will perform? Are your long-term expectations merely condensed into the short-term? Are you comparing your investments with an index every day, as described above? Given that most portfolios are allocated to perform in a particular manner over a time horizon much longer than one day, any daily expectations we have for our investments will necessarily be flawed. Any judgments we make based upon whether our investments have met those expectations will be flawed as well.

In the above example, Funds C and D are absolute return funds (designed to generated positive - though not necessarily large - returns in all market environments). By design, they invest in such a way that their returns have relatively little relation to what happens in the broader markets. By their very nature, they are the type of funds that provide the greatest diversification benefits to a portfolio but are also some of the most difficult funds to hold in an equity-dominated portfolio.

They work exceptionally well in periods like the first quarter of 2008 when the market is down but they almost always gain less than others (and the market) when the market rises. Often, their absolute returns as well as their risk-adjusted returns look attractive over the long run and they are added to a portfolio to diversify and often to protect when the market declines.

For exactly the reasons outlined above, it is exceedingly easy to feel negatively about them by watching the daily performance numbers. It is nearly impossible to create a daily expectation for this type of fund and the result is that many days will disappoint in some way. They rarely keep up with the market when it is up and there is always possibility for a decline regardless of the market's direction. It is exactly a result of their lack of correlation with the broader market that ensures the greatest diversification benefit to the portfolio as well as the greatest psychological burden on the investor.

So, Take the Long View
At Kobren Insight Management, however, we do look at daily returns. It's not so much to pass judgment on the fund's total return, but to primarily see if the fund is behaving as we expected given what we know about its risk characteristics and market exposures. First and foremost, a fund must behave in line with our expectations. That is crucial if we are to build appropriately balanced and diversified portfolios.

For most investors though, this level of high frequency monitoring is not necessary, and due to the reasons we mentioned earlier, it may even be counterproductive. In short, the best way for an individual investor to judge a fund's performance, and whether or not it is ultimately successful in generating a satisfactory return, is to see how it performs over time. When we say "over time," the ideal is to often judge a fund after a full market cycle, which is typically measured in years, not weeks or days.

-- Benjamin King, Senior Research Analyst