When you’re in the market to buy a car, most people would agree that there are other important criteria to look for besides “top speed” – and that other important characteristics like “safety”, “gas efficiency”, and “price” are also equally if not more important.
Just as when buying a car, I think there are other important criteria besides “total return” when considering an actively managed fund. Other important characteristics like “safety”, “efficiency”, and “price” are probably more important these days. These important criteria are really what investors should be scrutinizing ever-so-closely when deciding to add a new fund manager – or drop a current manager from the portfolio. If you can’t obtain these metrics from the manager or the fund and you are unable to calculate them yourself, then you really have no idea what you’re actually buying – and you probably shouldn’t be buying into it no matter how many free meals you get and how nice they are.
Here are the 4 important portfolio metrics that you need to know about your asset manager.
These metrics are the reasons why you pay higher fees to an active manager in the first place. If price is what you pay and value is what you get, then these portfolio efficiency and risk metrics are what you get. It goes without saying that these 4 metrics of your fund manager should be higher than the metrics of what a passive, low-fee index fund would have such as SPY, an ETF based on the S&P 500:
Sharpe ratio – A measure of portfolio efficiency. This is like your car’s miles per gallon; i.e. your car’s efficiency. It is the excess return above the risk-free rate divided by annualized standard deviation of returns. The higher ratio, the better.
Calmar ratio – A measure of drawdown risk. This is like your government 5-star crash rating on your car; i.e. a measure of both safety and risk. It is the CAGR / maximum drawdown. It is not as popular as the Sharpe ratio, but some would argue it’s actually more important. The higher the ratio, the better.
Correlation – A dimensionless measure of a fund’s price direction vs equity price direction. This would be like you taking the less-travelled backroads to get where you are going and avoiding all the interstate highway traffic congestion that everyone else takes which may increase their risk – but not yours – of being caught in a 20 car crash pile-up. The lower the number, the better.
Beta – A measurement of how risky a fund is relative to its benchmark, usually the S&P 500. This would be like driving a Porsche 911 Turbo vs a Toyota Prius. One car generally drives much faster than the other which increases risk because it is true that it is velocity kills people (or wins races). Personally, I prefer a lower beta – but I also used to drive a Prius too.
Not having your active fund manager’s performance/risk metrics is like buying a car and simply not knowing any of its important features and characteristics besides “top speed”.
Why are these particular 4 metrics so important to know with every manager or fund – both active and passive?
Sharpe and Calmar ratios are measures of portfolio efficiency and risk. So they standardize the manager’s returns to a per-unit level of risk that was taken to produce those returns. Would you rather have your car have high miles per gallon or low? Similarly, would you rather have your manager be efficient or inefficient with your money?
These metrics allow an investor to be able to make a true apples-to-apples comparison of portfolio characteristics (aka a manager’s performance!) vs another active fund to determine if the investor is getting his money’s worth – or not.
These metrics allow the investor to go one step further and categorize all of the active managers under consideration, run a portfolio optimization solver, and create a portfolio of portfolios custom-tailored to your particular risk standard or tolerance such as seen in Fig. 1 below:
Figure 1. The output of running a solver function that optimizes a portfolio of portfolios given explicit constraints.
What else can be done?
I would even suggest getting creative and building for yourself a comprehensive portfolio metric that works for you and your situation. For example, the formula could incorporate all 4 of the above metrics and allow investors to compare managers by using just one number rather than 4. Unfortunately, not all active managers want to share their risk/performance metrics with you (run away, don’t walk). In these cases, you might be able to calculate the metrics yourself if you have access to your active manager’s daily or monthly returns. Here’s just one way of incorporating all 4 metrics into one formula:
(Sharpe + Calmar) / (Correlation + 1) x Beta
The weights could be adjusted based on a client’s preferences. For example: If you preferred more drawdown protection, then you would probably emphasize and weight Calmar more. So your formula may look like ( 0.3 x Sharpe + 0.7 x Calmar) / (Correlation + 1) x Beta
All these metrics are heavily influenced by an active manager’s inception date. So, while one manager’s metric may be better than another manager’s metric, check to see both manager’s inception dates. The longer time the time has passed since the fund’s inception, the more weight you can give that manager’s metric.
Notice that CAGR is not listed as one of the 4 metrics. The reason is that if I’m going to pay fees to an active manager, then I don’t directly care about his/her returns. I care more about the amount of risk that he/she took to produce those returns, and the manager’s 4 risk metrics should beat, cost-adjusted, that of a low-fee, passive fund. When one considers the amount of debt on global sovereign and central bank balance sheets, the amount systemic risk that has been baked into the system, and the potential for increased volatility going forward, it would be foolhardy to judge a fund from just looking at CAGR alone.
Dr. Phillip Guerra
Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.