I am often asked why I recommend one fund over the other, or why someone’s favorite fund is not one of mine. There are a number of reasons – the fund may be too new, for example, and I may not have enough familiarity with it to make an assessment. In most cases, though, I find that after a more detailed review, I simply don’t think a fund’s past performance is repeatable. So what goes into such a review? I start with six key quantitative factors.
To determine whether a manager’s past performance is repeatable, I take a multistep approach that involves both quantitative screening and more detailed qualitative analysis. Here, I want to concentrate on my basic quantitative screening process.
Looking for added value
The quantitative analysis is based on one major premise: My belief that if I am going to pay a management fee to a fund manager, that fund should at least be able to deliver some form of added value over a comparable exchange traded fund (ETF). That value can come in a couple of different forms: higher returns or lower volatility, or ideally a combination of the two. If a manager can’t add any value over an ETF, then there is no point in investing in it.
My quantitative screening process looks to weed out those managers that have not been able to add any value. This screening measures and scores a number of key risk and return factors, weeding out those funds that have failed to deliver. I tend to focus my quantitative analysis on the most recent 36- and 60-month periods.
6 essential quantitative screens
Here are the factors that I pay particular attention to:
Alpha – This measures the additional performance a fund manager has been able to generate over the period being reviewed. If the Alpha is positive, the fund manager has been able to outperform their benchmark on a risk-adjusted basis. If it is negative, they have not.
Sharpe Ratio – This measures how much return a fund has been able to generate for each level of risk it has taken on. The higher the Sharpe Ratio, generally the better. When I am reviewing a fund, I compare its Sharpe Ratio with its benchmark. I tend to favor funds that have a higher Sharpe than their benchmark.
Volatility – Most investors tend to prefer investments that let them sleep at night. One way to measure this is with a fund’s standard deviation of returns. The standard deviation measures the variability of return. Those with a low variability are preferred over those with a high variability. As with the Sharpe Ratio, I measure the volatility of a fund against its benchmark, favoring those that a less volatile on a relative basis.
Information Ratio – This measures a portfolio manager’s ability to consistently deliver returns that are higher than the benchmark. Generally, the higher a fund’s information ratio, the more consistently the manager has outperformed the benchmark. If it is negative, the manager has failed to add any value.
Batting Average – To determine this number, I take the number of months a fund has outperformed its benchmark and divide it by the number of months being considered. It has to be at least 50%; otherwise, it has lagged its benchmark more often than it has outperformed it.
R-Squared – This measure shows the percentage of a fund’s movements that can be explained by the movements of the benchmark. It is measured between 0% and 100%, with 100% representing a fund that is essentially the same as its index. I like using R-Squared mainly because it helps me to identify those funds that are more or less closet index funds. I believe that if a fund is going to beat its benchmark, it can’t be its benchmark. I tend to prefer funds that have an R-Squared of 80% or less, assuming all other quality measures are in place.
Each factor is given a score of between one and five, with one being less favorable and five being the most favorable. Once scored, the individual scores are then averaged, and ranked, allowing me to focus on those funds that have a demonstrated history of providing strong risk-adjusted returns. Once I have narrowed down my focus, I can then take a much deeper dive, focusing on more qualitative factors such as the manager, investment process, and risk management.
Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson's Top Funds Report and Mutual Fund and ETF Update, offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.
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