Fund evaluation

The first factor to consider when evaluating an investment fund’s record is the investment performance, measured in returns as a percentage of assets. This is the most widely quoted statistic for the majority of funds.

The second factor is risk, which receives less attention, perhaps because it is harder to define and measure.

Funds with a higher level of risk should deliver higher returns in the long run to compensate investors for the risk of low or negative returns in the short term.

How should I interpret returns?

Returns are normally measured over one year. Results from shorter or longer periods can be annualised to make comparisons easier.

For example, a six-month return of 5 per cent would give an annualised return of just over 10 per cent. But do not read too much into this – six months is not a long enough period to assess the quality of a fund.

Above all, use a healthy dose of scepticism. Remember the warning that past performance is not necessarily indicative of future results.

And watch out for fund promoters who pick return periods to show their funds in a more favourable light. The standard periods are one year, three years, five years and total returns since the fund’s launch.

What else should I watch out for?

Returns should be quoted as total returns, which include dividends paid to investors as well as capital gains in the form of a higher unit price or share price. You cannot work out returns simply by observing the price change.  

In addition to this, costs such as annual management fees should be deducted from gross returns to reflect how much money actually goes into investors’ pockets.

What level of return is a good return?

As a rough rule of thumb, annual returns from bond funds should be about 1 or 2 percentage points above cash returns (i.e. what you would get if you put your money into a savings account), equity funds should give at least 4 or 5 percentage points above cash, and property funds are somewhere in between.

But this really only applies if you are taking a long-term view.

The best way to measure fund managers’ performance is their return relative to the benchmark. A fund’s benchmark is normally an index such as the FTSE 100. There are hundreds of indices for different regions and asset classes. Some funds, particularly hedge funds, use a spread over cash returns as their benchmark, such as cash plus 5 per cent.

If a fund manager beats his index after fees, he is offering a good deal. Do not be fooled by absolute returns. For example, a UK equities manager who made a return of 2 per cent in 2002 – an exceptionally tough year, when the FTSE All-Share index fell by a quarter – did very well.

On the other hand, one who made a 5 per cent return in 2003, when the market rose by nearly a fifth, was underperforming.

The margin by which a manager beats his benchmark is known as alpha, which is a widely used measure of skill in fund management. Generating below-benchmark returns creates negative alpha.

What about risk?

The key measure of risk is volatility – that is the variation in returns. This is usually measured by standard deviation, where a higher number means more volatility.

For example, if a fund had an average return of 10 per cent and a standard deviation of 3 per cent over the past 20 years, that means that in a given year there was about a 70 per cent chance that its return would be between 7 and 13 per cent, and a 95 per cent chance that it would be between 4 and 16 per cent. Historic risk levels, like historic returns, are at best a rough guide to future performance.

Do any measures combine risk and return?

Yes – the three main ones are based on alpha. The Sharpe ratio is alpha divided by standard deviation of returns, the Treynor measure is alpha divided by beta (a measure of volatility relative to the market), and the information ratio is alpha divided by the standard deviation of returns in excess of the benchmark. In each case, a higher number is better.

What about correlation?

Sophisticated investors look at a fund’s correlation with other investments. By combining investments that have a low correlation with each other you can reduce the volatility of your returns without necessarily reducing the level of returns.

 For example, your US equities fund might perform well when your UK property fund is doing badly, and vice-versa.

Correlation varies from -1 to 1, and the lower the correlation between your investments the better. In practice, correlations are normally positive, since a negative correlation means that two asset values normally move in opposite directions.

Bear in mind that correlations between almost all asset classes and funds tend to increase when a crisis causes markets to panic. So although diversifying your investments reduces risk, it offers less protection when things go badly wrong.

You can also look at a fund’s correlation with its benchmark to see how active the manager is. If the correlation is close to 1, the fund may be a closet tracker that charges active management fees but does little more than buy the assets that make up the benchmark.