Consumers of investment management might consider three different methods to analyze investment returns. The first method is to look at absolute returns in the context of your financial plan. If the portfolio return was 7% annualized for ten years, was that return high enough for you to achieve your financial goals? What about 3% annualized returns, or 12% annualized returns? Of course, looking through the lens of absolute returns would disqualify negative returns as helping anyone to achieve their goals, so investors often look to other methods to evaluate portfolio returns. Today it is rare to find a manager in any asset class, including hedge funds, who claims to be able to consistently generate absolute returns.
The second method of evaluating returns is to look at relative returns. This helps investors to analyze returns throughout the entire market cycle in the context of returns available by investing in other markets, or with other managers. Comparing portfolio returns to indexes of cash, bonds, large and small cap U.S. stocks, international stocks, commodities, or the universe of active managers in each asset class, can help to clarify whether returns are excellent or terrible. For example, if a U.S. large-cap equity manager trails the return of the S&P 500 Index, a reasonable consumer would probably want to find out why. One problem with relative return analysis is that investors tend to compare returns to the best performing asset class over any defined period of time. Comparing a large cap U.S. equity manager to cash in a bear market is sure to be disappointing. Common sense must prevail in choosing the appropriate benchmark.
The last method of evaluating portfolio returns is to evaluate risk-adjusted returns. Here the investor not only analyzes returns, but also considers how much risk, or volatility, the portfolio manager took to get those returns. The Capital Asset Pricing Model (CAPM) gives investors one invaluable tool to accomplish this. The model compares the volatility of the portfolio to the volatility of a benchmark portfolio and predicts a portfolio value based on relative risk. If the portfolio has higher returns than the model predicts then the manager is considered to have generated “positive alpha.” Positive alpha is the holy grail for professional money managers and consumers of investment management would be wise to consider risk, as well as return, when evaluating portfolio managers.
One last point to consider is that risk seems to be irrelevant when evaluating portfolio returns after the fact. Once the return is booked, the only important consideration is return. When looking in the rearview mirror, all risk management decisions look crystal clear. The manager with the highest return obviously did the best job of managing risk. However, the reality is that investment decisions are made in real time where risk is an overwhelming consideration for investors. This is especially true considering the elevated systemic risk inherent in today’s financial markets. Therefore, good consumers of investment advice need to consider more than just prior returns when evaluating money managers. An equally, if not more important consideration, is investment process. How did investment decisions get made and what considerations were given to investment risk at the time? Pinnacle clients and interested spectators can find three years of real time writings on the financial markets in the archives for our Echoes from the Pit column. You’ll find that in the right sidebar of this page.
Copyright: blueximages / 123RF Stock Photo