Photo: iStock
Photo: iStock

When evaluating performance, see the whole picture

Without using the right metrics and evaluating risk-adjusted returns, an investor cannot see the whole picture, which may inadvertently lead to clouded decisions

In today’s day and age, several investment options are available across equity, fixed income and alternative assets. It has become crucial to make a wise investment decision based not only on one’s risk profile but also on prudent fund managers with proven track records and those who have fundamentally sound investment styles and approaches.

After investing, the next important task is tracking and evaluating performance.

Performance evaluation helps the investor assess whether her return objectives are being met, how the fund manager is performing, if there is a need to rebalance or switch out, and, at times, to determine the manager’s compensation if it is linked to the performance.

However, multiple performance measurement metrics like CAGR, absolute returns, time weighted rate of return, rolling returns, annualised returns, alpha and others confuse an investor and can lead to incorrect comparisons. These have to be seen in context.

Performance evaluation has to be done at two levels— the fund managers’ performance and the portfolio performance. Most investors use these interchangeably, but it is imperative for one to understand the differences and judiciously use the right one before taking any decision.

Two investors who start investing on the same date in the same fund may witness completely different returns of their portfolio if they have made follow-on investments and redemption. However, for both investors, the fund manager’s performance is the same as the fund does not perform differentially for them. The difference in portfolio performance is owing to “investor’s decision" around timing and quantum of inflows or outflows. The gap in understanding of this difference often leads to one investor being unhappy with a particular manager while the other is quite satisfied.

Since a fund manager should not be judged based on investor’s timing of cash flows, the correct metric to evaluate a fund manager’s performance is time weighted rate of return (TWRR). It eliminates the distorting effects created by inflows or outflows, so it is also called fund manager return.

Portfolio performance is a combined outcome of the fund manager’s performance and cash flow actions in the portfolio. The best measure for this is a metric called money weighted rate of return, commonly known as XIRR or IRR. A suitable comparison with a relevant benchmark index mirroring the cash flows of the portfolio will provide the extent of outperformance and efficacy of portfolio management. There are also other more complicated ways to separate total performance between fund manager and cash flow decisions.

After segregating investor and manager performances, the next hurdle is to compare performances of different fund managers. Here also, an “apple to apple" comparison is important to arrive at right conclusions.

For manager’s performance comparison, a few common metrics used are—CAGR between two points of time (historical performances over 1, 3, 5 years), risk metrics (beta, standard deviation), performance relative to benchmark, and risk adjusted returns (Sharpe Ratio, Treynor Ratio). Point to point CAGR returns over different time periods are the most commonly used performance metric to rank or evaluate funds. However, at times the impact of entry or final levels distorts returns. An exceptionally good or bad month (at initial and final date of point to point comparison) can make even 1-, 3- or even 5-year returns of the same fund very different.

Rolling returns and risk weighted measures are some methods to avoid the above issues of point to point historical performances.

A few other parameters to be kept in mind before evaluating fund manager’s performance is to choose the right peer set to compare. These peer sets are chosen around investment style (growth versus value) or market capitalisation (appropriate benchmark).

Performance relative to benchmark: This becomes important when deciding between choosing passive low-cost fund management and active managers. For example, during calendar year 2017, most large-cap equity funds delivered 32-35%. If we see this on a standalone basis, it looks like an exceptional year for the large-cap funds; however, one also needs to be aware of the fact that during this period, Nifty 50 was up 29%. It is only when one compares portfolio performance to a benchmark that one can indicate the extent to which the investment has outperformed or underperformed.

While relative comparison to benchmark is essential, choosing an appropriate benchmark is also critical. One cannot compare a mid-cap or a small-cap focused fund with a Nifty 50, an index consisting of top 50 large, blue-chip and most liquid stocks. As observed in the last 2 years, mid- and small-cap funds along with their respective benchmarks have outperformed the large-caps by 15-20%. However, most mid-cap funds have delivered returns in line with the mid-cap index, or in a few cases, they have underperformed the mid-cap index.

Portfolio and fund manager’s performance measures should be a key aspect in the investment management process. These tools provide the necessary information for investors to assess how effectively their money has been invested or may be invested. Remember, portfolio returns are only part of the story. Without using the right metrics and evaluating risk-adjusted returns, an investor cannot possibly see the whole picture, which may inadvertently lead to clouded decisions.

Rajesh Saluja, MD & CEO, ASK Wealth Advisors Pvt. Ltd