FOR RETIREMENT Bulls, bears and beyond Understanding investment performance and monitoring Dan Weber, CFA, CMT, AIF Director of Investment Strategies Funds Management September 10, 2012 2012 Lincoln National Corporation
Objectives Understand important mutual fund risk and return measures Demonstrate the complexity of selecting investment managers Provide a reference tool for day-to-day work activities Answer questions 2
Mutual fund considerations Statistical measures tend to be poor predictors of future performance, therefore, consider the following factors: Historical performance Risk Risk-adjusted measures of performance Style analysis Expenses Manager approach and experience Fund family expertise and integrity 3
Historical performance 5- and 10-year periods are best 1- and 3-year are important Compare funds to: Market benchmark Peer group/category Performance is important, but should not be viewed in isolation 4
Risk Risk = volatility Several ways to measure: Standard deviation Beta Tracking error 5
Standard deviation Commonly used risk measure Measures how much a fund s return varies around the average (mean); it is an absolute measure (standalone number) Compare to category average and benchmark Higher standard deviation generally indicates greater risk When comparing funds with similar performance, lower is better 6
Beta Based on risk relative to a fund s benchmark Easy to interpret: Beta > 1 fund has more risk than benchmark Beta < 1 fund has less risk than benchmark Beta = 1 fund has same level of risk as benchmark In theory: Fund with beta of 1.1 would be expected to gain 11% if benchmark went up 10% Would also lose 11% if benchmark went down 10% Beta expected benchmark return = expected return for the fund 7
Beta, cont d. Value of a beta coefficient depends upon how highly a fund is correlated (R 2 ) to an index. If a fund is not highly correlated to a market benchmark, then the beta is not statistically viable. Hint: If R 2 is less than 70%, the beta value is not a good indicator of risk. 8
Tracking error Generally thought of as a divergence between the price behavior of a fund/portfolio and the price behavior of a benchmark Basically tells the difference between the return received and that of the benchmark 9
Risk-adjusted return measures Why not just evaluate the fund s actual performance? Because we want to get paid for the risks we take. Four measures (not exhaustive) Alpha Sharpe ratio Information ratio (IR) Morningstar star rating 10
Alpha Positive means adding value over risk taken Definition: difference between a fund s expected returns based on its beta and its actual returns Can be interpreted as the value the manager adds above the market risk that the fund is taking Can be positive or negative 11
Sharpe ratio Positive = good The higher a fund s Sharpe ratio, the better its returns relative to the risk Definition: fund s excess return over risk-free investment (90-day T-bill) divided by the fund s standard deviation = (Fund return 90-day T-bill return)/fund standard deviation Example: In 2004, XYZ fund returned 20% with a standard deviation of 10; 90-day T-bill returned 5%. Sharpe ratio would be: (20 5)/10 = 1.50 12
Information ratio Positive = good Definition: fund s excess return over its market benchmark divided by its tracking error Information ratios are not consistent across markets (equity or bond), style or capitalization Like Sharpe ratios, it is best to compare IRs within a category (Fund return Market benchmark return)/fund tracking error Tracking error = standard deviation of the fund s excess returns 13
Morningstar star rating Based upon comparison of a fund s risk-adjusted returns with those in its category Purely mathematical rating performed each month analysts don t assign rating or give subjective input Top 10% in risk-adjusted returns = Next 22.5% in risk-adjusted returns = Middle 35% in risk-adjusted returns = Next 22.5% in risk-adjusted returns = Bottom 10% in risk-adjusted returns = 14
Morningstar star rating, cont d. Each share class is rated separately NOT a forward-looking forecasting tool Age of the fund has a BIG impact on star ratings 0 3 years: No star rating 3 5 years: 100% 3-year rating 5 10 years: 60% 5-year rating/40% 3-year rating 10+ years: 50% 10-year rating/30% 5-year rating/ 20% 3-year rating If a fund changes categories, its historical record is given less weight in these calculations, based on the degree of the change 15
Bond statistics Effective maturity Weighted average of the maturities of all the bonds in a portfolio Longer-maturity funds are generally considered more interest rate sensitive than shorter counterparts Duration (average) A time measure of a bond s interest rate sensitivity Higher duration means a bond s return (and the aggregate fund) will change more than a bond with lower duration Remember the inverse relationship between bond prices and interest rates 16
Bond statistics, cont d. Average credit quality Weighted average of each bond s credit rating Ratings provided by S&P or Moody s Anything below BBB for taxable bonds is considered high-yield (junk) 17
Style analysis Style analysis provides interesting information How the fund has been managed Check the prospectus objective to determine mandate Has the fund s Morningstar Style Box changed over time? Look for consistency that matches the objective and stated approach of the fund Value Blend Growth Large Cap Mid Cap Small Cap 18
Style analysis: Mid-cap growth index fund (pure) Holdings-based Style Trail Source: Morningstar Direct 19
Style analysis: Mid-cap growth fund (style pure) Holdings-based Style Trail Source: Morningstar Direct 20
Style analysis: Mid-cap growth fund (ultra-growth) Holdings-based Style Trail Source: Morningstar Direct 21
Style analysis: Mid-cap growth fund experiencing (style-drift) Holdings-based Style Trail Source: Morningstar Direct 22
Questions? 23
Disclosure 24
Bulls, bears and beyond Understanding investment performance and monitoring Lincoln Financial Group is the marketing name for Lincoln National Corporation and its affiliates. Affiliates are separately responsible for their own financial and contractual obligations. 25