In my last two columns, we've discussed the outsized role that luck plays in the world of investing, how to go about establishing our overall asset allocation, determining our risk tolerance and projecting our expected returns. Now we need to know what variables to look for to select better-than-index returns—or how to identify skill in the marketplace.
To do this, we're going to need the following tools:
The right benchmark for each of our asset classes
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Reliable data sources
An understanding of the following metrics:
- Alpha
- Tracking Error
- Manager experience and tenure
- Consistency of excess returns
- Costs
A way to manage a potentially limited selection (i.e. inside of a 401(k) plan)
Let's start with selecting the appropriate benchmark for the hypothetical four-asset portfolio we developed in my last article. If you are going to evaluate skill, you have to have a consistent, reliable comparison. This isn't always as easy as it sounds, as two funds with similar sounding names can use very different comparison benchmarks and possibly even have two very different objectives. In our case, we will use the following asset classes and recommended benchmarks:
- U.S. Stocks – Standard & Poor's 500-stock index
- International – MSCI EAFE (Morgan Stanley Capital International Europe Australasia and Far East) index
- U.S. Small Cap – Russell 2000
- Bonds – Barclays U.S. Aggregate Bond index
(You may note that I am using the Russell 2000 index for small cap U.S. stocks. This is because the tools we will be using may not have access to the Dimensional U.S. Small Cap index that I used in my last article.)
Now we need some good data sources. The tools I use are Morningstar, Fiduciary Analytics (from the Center for Fiduciary Studies), Evestment, TD Ameritrade's fund and ETF research and information from the mutual fund's own sites.
When evaluating skill, and the potential for persistently better results than the index, there are a few statistics that can help us. The first is alpha, which measures the active return on an investment, or the return that is in excess of the comparison benchmark. We may be interested in average alpha, over a period of time, such as three years, five years or 10 years, but I recommend looking also at this metric on an annual basis, to get a sense of consistency. Averages, whether they are performance averages or other statistical measures, tend to get corrupted easily by big differences in select periods, so look at each year.
When you hear the term "tracking error," I want you to think of "error" as "deviation" or difference" as this measurement is focusing on the degree of differential in returns of the investment over its benchmark. If you see that the fund is exhibiting a significant tracking error, but the returns are consistently under the benchmark, you should look closely at replacing the fund or not selecting it in the first place. What we are looking for is significant tracking error and returns that are consistently better than the fund's benchmark.
If our screening is progressing well at this point, we want to look into the experience of the manager, or team, and their years of running this particular investment. I'd like to see 10 years of overall experience and at least 3 years with the fund. This is where we will go to the fund website and look at annual reports, fact sheets, manager commentary, etc. You want to get a sense of the character and competence of the management team. I'd also like to know if the fund family has a record of being good fiduciaries and whether the corporate culture represents those values.
Costs are no small factor, and I am very sensitive to the management costs involved in the funds we use. If we are successful in finding skill and therefore an advantage in terms of performance, we may be willing to pay a little more for it. But you also have to take into consideration the type of fund or asset class you are investing in. If I were to rank the typical asset classes in terms of paying up for skill, I'd rank them as follows (from lowest fee expectation to highest):
- U.S. Money Market/Short-Term Bonds
- U.S. Government Bonds
- U.S. Corporate Bonds
- U.S. Large-Cap Stocks
- U.S. Mid-Cap Stocks
- International Large-Cap Stocks
- U.S. Real Estate
- U.S. Small-Cap Stocks
- International Bonds
- International Small-Cap Stocks
- Emerging-Market Stocks
So if you have a promising U.S. government bond fund that is charging a higher fee than the average U.S. large-cap stock fund, you may have a problem. Take for example the institutional shares of PIMCO Long-Term U.S. Government Income Fund versus the R5 shares of American Funds Growth Fund of America. The PIMCO bond fund has an expense ratio of 0.48%; the American Funds stock fund of 0.38%. Yes, this does happen in the real world!
Finally, having a limited universe of investments to choose from, as is common in a company 401(k) or on many broker-dealer platforms, can complicate our task. In this event, you will have to combine these principles with a ranking process and make the best choice you can within the universe available to you. If the choices are too limited, you might consider requesting that your employer review the plan and make changes. That sounds radical, but you are within your rights to do so if you have a sound basis.
Doug Kinsey is a partner in Artifex Financial Group, a fee-only financial planning and investment management firm based in Dayton, Ohio.