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Measuring the quality of an investment process is one of the more difficult tasks in the world of finance. In theory it should be simple. How much is a fund up or down. That data is readily available in the financial press and on websites such as Trustnet, Citywire, Morningstar and the Financial Times Managed Funds. But life is more complicated than that. For a start it is important to know what the asset class has done and that is usually expressed as the performance of an appropriate index. A commodity fund that has risen 50% may look fantastic. But if all commodity shares have done well and the index is up 75% then its performance looks less impressive. So the first thing to determine when assessing performance is to discover what the index has done so that you know what the background is. The Financial Times is always a good source of data. Then you need to look at the index to see if it includes dividends, known as a total return index, or a simple capital value. A fund that doesn't pay out dividends but keeps them for reinvestment will look good when compared to the capital value of an index like the FTSE 100. It might not look so clever if it is compared to the total return of the FTSE 100.
As The Munro Fund is benchmarked to the FTSE 350 we compare the accumulation units to the FTSE 350 total return index but we also include the capital only index on these graphs to show the difference.
The red herring of quartile rankings
Many funds assess their performance against their peers by quoting where they sit in terms of quartiles. The top 25% of funds will occupy the first quartile, the next 25% the second quartile and so on. Intuitively, that suggests anything in the first or second quartile is good. There is a catch though. This method of ranking only considers the funds, not the index being used as a benchmark. By definition therefore half the funds will be above the average of all the funds, but if the average is below the benchmark many, if not all, funds in the second quartile could be behind the index. As an example consider the five years to end November 2008. Over that period 141 funds in the IMA All Companies Sector, or 54% of them, beat the average and made it into the first or second quartile. That looks good until you realise that in that period only 57 actually beat the market. In other words, unless a fund was in the first quartile it didn't beat the market. We prefer to focus on returns against the benchmark rather than quartile rankings.
Performance is about risk as well as return
As we know when buying a car or a mobile phone there is more to assessing a product than how fast it goes or how much data it can transmit. Features like fuel consumption and battery life usually suffer in high performance cars and phones. So it is with investment funds. Here the trade-off is with risk. Good performance, defined as the excess return over the index, in a fund can usually be achieved for a while by increasing risk. To do that a manager will avoid some shares but hold large positions in others relative to the index. The amount of risk he is taking is normally measured by tracking error and it quantifies how closely a manager's pattern of returns follows the index. excess return is good and risk is a necessary evil to get that performance. So you need some, but not too much and it has to be risk that generates gains, not losses. Evaluating the tracking error will allow an investor to assess how much risk a fund has taken in absolute terms and in comparison with its peers. Ideally, you want a little bit of the right sort of risk generating lots of excess return. To determine if the manager is getting enough excess return for the risk he is taking it makes sense to divide that excess return by the tracking error to calculate the information ratio. Anything over one means the manager has delivered more return than the risk he has incurred. The Munro Fund publishes all these ratios on its websiteand on its fact sheets. These data are also available on theTrustnet website.
The investment objective of The Munro Fund is to deliver the total return of the FTSE 350 index with the lowest possible risk.
That means the excess return of the fund is never going to be enormous, nor should it ever be horrendous. By taking lots of little risks against the index, i.e. holding slightly larger or smaller positions in each stock, our aim is to generate sufficient excess return to cover the cost of running the fund. While it would be nice to beat the index on a consistent basis we think that is a very demanding target. It may happen in some years, but it may not in others especially if the market becomes obsessed with growth stocks again. But, over a period of years, we hope to deliver returns that are closer to those of the index than from traditional passive tracker funds. In contrast to an active fund these returns will be less volatile and more reliable. It will suit investors prepared to accept modest, but consistent, returns. For that reason we suggest potential investors pay as much attention to the risk profile of competing funds as to the excess return.
Remember that past performance is no guide to future returns and that the value of your shares and the income from them can go down as well as up and you may get back less than you invested.
Check out Munro Fund performance at:
