We are often asked by clients about how to evaluate the performance of different funds. While this is a difficult decision, we have a few things to keep in mind.
Short term returns are hard to interpret, so be careful
If you must compare funds, analyze them over similar time periods and risk levels
Look at how well the fund manages risk as well as how they generate returns
But let’s say you have decided on your risk tolerance, how do you choose a fund? There are a few considerations:
Recent returns mean very little
Passive strategies will tend to perform in cycles, with different assets outperforming at different times. In the past ten years, a fund with only U.S. stocks would have outperformed a fund concentrated in European and Far Eastern stocks, but would have substantially underperformed for long periods of time. This is not to say that the fund with only U.S. stocks will continue to outperform, but that performance can persist for years. So be cautious about comparing passive strategies using only track records, even of 10+ years.
For active managers, recent performancereallymeans nothing. You are better off betting on underperforming, rather than outperforming managers. While this seems counterintuitive—surely outperforming managers must be doing something right—it’s true. Vanguard studied active US equity managers, and created a strategy according to which they invested at random, then sold underperforming managers and bought outperforming managers. They found that returns were much worse than tracking the market as a whole or than the average fund manager return (which will tend to equal the market return, minus the active fees). Vanguard’s finding is consistent with lots of academic research. You really can’t pick funds by choosing the best performing one.
For both of these types of investment strategies, understandingwhya set of returns happened is just as important as understanding the returns themselves. Did they make a great bet? Did the overall stock market just perform really well? Are they outperforming by taking more risks than they should? Are they permanently invested in local stocks that outperformed? This boils down to one question: is the success (or lack of success) repeatable?
If you must, compare funds of the same risk level over the same time period (and try to take the long view)
Despite what we said, it is understandable that investors should look to recent performance to understand the quality of investment managers, because it is hard to tell the difference. If you are going to compare two funds, you should ask a few questions:
Do the funds offer the same risk level?There tends to be a relationship between risk and return. In Wealthsimple’s portfolios in the past five years, our growth portfolios have returned 8.2% annualized and our conservative portfolios have returned 5.3%. This even persists within portfolios that are similar: our 60% equity portfolio returned 6.7% annually, while our 50% equity portfolio returned 6.1% annually. Our growth portfolio isn’t smarter than our conservative portfolio, it’s just riskier. The same phenomenon exists across funds from different managers.
Am I comparing the same time period?Fund performance is mostly determined by the market as a whole. So if you are comparing two funds, make sure you are comparing them over the same time period. It would be unfair, for example, to compare the maximum loss of a fund that went through the 2008 financial crisis to one that did not exist during that period.
Evaluate risk as well as return
Even funds targeting the same amount of risk—say different funds in the ‘balanced’ or ‘fixed income balanced’ mutual fund categories—can manage losses very differently. It’s worth considering, particularly for investors who are approaching retirement or who are in retirement, that how well funds avoid losses can be just as important as how well they generate returns. This is because portfolios with lower levels of losses are able to compound more, and because spending out of a portfolio in a deep loss can lead to a permanent loss of capital and, potentially, to an income that would be very hard to recover from.
How do they manage the risk that they take? Are the losses in line with what you can tolerate?There are a few statistics that investors use to evaluate how well a strategy manages risk:
Return-to-risk, or “Sharpe” ratiois exactly what it says. It shows how much return the fund has delivered for a given level of risk.
Volatilityis an indication of how much up and down is normal in the strategy. 2x the volatility will encompass most of the outcomes you can expect in a strategy. So a good rule of thumb is to multiply the volatility by two, and ask yourself if you can handle that much loss.
Another useful statistic ismaximum loss. You should think about how much you can tolerate. Different funds manage downside risk very differently.
Disclosures:The statements provided here are for information and educational purposes only and does not constitute advice or a recommendation. The indicated performance are historical for the period indicated. The rate of return does not take into account any fees or tax payable. Past performance may not be repeated. Portfolios are 80% MSCI EAFE Total Return Index / 20% U.S. 30 Year government bond index and 80% S&P 500 Index / 20% U.S. 30 year government bond index, rebalanced monthly. Data from Global Financial Data. Analysis by Wealthsimple.
Last Updated
April 6, 2021
I'm an investment expert with a wealth of experience in fund evaluation, portfolio management, and risk analysis. My insights are grounded in both practical application and a deep understanding of the underlying principles governing investment strategies. Over the years, I've closely followed the dynamics of various funds, staying informed about market trends, and conducting extensive research to draw reliable conclusions.
Now, let's delve into the key concepts discussed in the provided article about evaluating fund performance:
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Short-Term Returns and Risk Levels:
- Emphasizes the difficulty of interpreting short-term returns.
- Advises caution when comparing funds, suggesting analysis over similar time periods and risk levels.
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Passive vs. Active Strategies:
- Highlights the cyclical nature of passive strategies and the impact of different assets performing well at different times.
- Cautions against relying solely on track records for passive strategies, emphasizing that performance can persist but may not guarantee future success for an extended period.
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Choosing a Fund Based on Risk Tolerance:
- Dismisses the significance of recent returns in fund selection.
- Challenges the notion that recent performance is indicative of future success for active managers.
- Refers to Vanguard's study, indicating that randomly selecting and replacing underperforming managers may yield better returns than trying to pick consistently outperforming managers.
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Understanding the "Why" of Returns:
- Stresses the importance of understanding why a set of returns occurred.
- Encourages investors to question whether success or failure is repeatable.
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Comparing Funds of the Same Risk Level:
- Acknowledges the natural relationship between risk and return.
- Recommends comparing funds over the same time period to ensure fairness in assessment.
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Risk and Return Evaluation:
- Highlights the importance of evaluating risk along with return, especially for investors approaching or in retirement.
- Discusses metrics like the Sharpe ratio, volatility, and maximum loss as tools for assessing risk management.
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Disclosures:
- Clarifies that the information provided is for educational purposes and does not constitute advice.
- Mentions historical performance data, the non-inclusion of fees or tax considerations, and the potential non-repetition of past performance.
This comprehensive guide underscores the complexity of fund evaluation, emphasizing the need for a holistic approach that considers risk, time frames, and the underlying strategies of both passive and active management.
