How to Tell if a Fund is All it Claims to Be

Elizabeth: Professor Evensky, is this going to be on the test?

Clay: The ad read “It’s the only domestic stock fund actively managed by professionals with performance that ranked it in the top 10 percent for the past one, three, five, ten, and fifteen years and below average risk.”

HE: Thank you, Michael and Clay. So let’s review some of the terms we’re using here. Elizabeth, what is an actively managed fund?

Elizabeth: Hmm, sorry. I think I was out the day we covered that.

HE: Lisa?

Lisa: “Actively managed” refers to a fund where the manager actively trades the investments with the goal of outperforming an index return benchmark.

HE: And how is an actively managed fund different from an index fund?

Clay: Unlike the actively managed fund, an index manager makes no decisions about what stocks or bonds to buy. He simply wants to own all of the investments listed in the index. If the index drops a stock and adds a new one in its place, the index manager will sell the stock that was dropped and the one that had been added to the index.

HE: So where did you start your evaluation? Anybody?

Cagla: I started with the three Ps: Philosophy, Process, and People, and I was impressed. Management seems to have a credible philosophy, a thoughtful process, and experienced people, although I noted that current management has only been in place for about two and a half years. [See Chapter 13, “The Three Ps of Investing,” for more information.]

HE: You’re on a roll. Who’s next?

Kristin: Well, having passed the three Ps, we then need to evaluate performance. Our clients can’t get yesterday’s returns, but if past performance is good and the fund passes the three Ps, our clients stand a chance of enjoying good performance in the future.

HE: Okay, how would you go about evaluating performance? And performance compared to what?

Lisa: I would begin by determining what sandbox the manager is playing in and select appropriate investable indexes to compare the fund to.

Elizabeth: Excuse me, um, “investable indexes”? HE: Who can explain what an investable index is?

Lisa: It’s a mutual fund or Exchange Traded Fund (they’re called ETFs), available to public investors that have the goal of earning the return of a market index at low cost. For example: the iShares Core S&P 500 ETF seeks to track the results of the S&P 500 that measures the performance of large-capitalization stocks in the United States stock market. The annual fund cost is only 0.07 percent.

HE: Very good. Now, what’s a “sandbox”? How are you going to determine which sandbox it is? And why investable indexes?

Lisa: By sandbox we mean the nature of the underlying investments. In this case, the fund is a domestic stock fund, so we need to determine the size of the companies the fund invests in and the manager’s valuation orientation, so we can know the universe of managers to compare its performance to.

Elizabeth: “Valuation orientation”?

HE: Can someone explain valuation orientation? And tell us how we go about determining the universe for comparison.

Kristen: Generally, stocks are categorized as “growth,” “value,” or “core.” Growth companies are ones investors believe will have significantly improving profits. The stock price tends to be relatively high compared to the company’s current earnings, as investors are paying up for those rapidly improving profits.

Value stocks tend to be relatively cheap based on current earnings, as investors do not have great expectations for the firm’s future profits.

Core stocks are those that have mid-range expectations for future profits. Professionals use a variety of metrics to determine what category a stock falls in.

One of the most common is the stock’s price-to-book ratio. That’s simply a number that tells you how much you have to pay for a share of stock to buy $1 of the company’s book value. For example, the stocks that make up the S&P 500 index have a price/book ratio of about 2.6 while the growth stock portion of that index is 3.8 and the value portion 1.9. When we look at a fund that’s investing in S&P 500 kinds of stock, we’ll look to see how the fund’s P/B ratio compares. If it’s in the 1.9 range then we consider it value, in the 2.8 range growth and core in between.

HE: Elizabeth, are you with us on this?

Elizabeth: Not really, sir.

HE: John, define average capitalization for us.

Kristin: Capitalization refers to the financial size of a company. It’s calculated by multiplying the current price of a stock, times the number of shares of the company. So, for example, if a company has 100,000,000 shares outstanding and the stock is trading at $30 it would have a $3 billion capitalization. To give you an idea, the average of stocks in the S&P 500 is more than $60 billion. Although there is no hard and fast rule, generally we would consider stocks with capitalization of less than $2,000,000 small cap; between $2 and $5 billion mid-cap and more than $5 billion large cap.

HE: Okay. And why are we comparing the fund to investable indexes and not to an index?

Elizabeth: Professor Evensky, is that going to be on the test?

Clay: You taught us last week that an index is generally a more rigorous standard than a peer benchmark. But if our clients can’t invest in an index, using one for comparison may be interesting but not very practical.

Sean: The good news is that today, with the large universe of exchange-traded fund index investments, we can invest in almost any index.

Elizabeth: I don’t seem to have any notes on exchange-traded funds.

HE: Very good. Sean, where might we look for the information we need to evaluate funds?

Sean: Certainly we’d want to look at the fund family website, and to get an independent evaluation, we’d look to Morningstar data. It is available in programs for professionals and on the Web for retail investors. You told us Morningstar is the Rolls Royce of the profession.

HE: Okay. What’s next in our evaluation? And what did you find?

Sean: I found the price-to-book and capitalization to be in line with the mid-cap growth universe. For comparison, I selected two exchange-traded funds (ETFs): iShare S&P mid-cap growth and iShare Russell mid-cap growth. Besides the capitalization and price-to-book metrics being similar to the active fund, the correlations with both indexes were high at 0.94.

HE: Thank you, Sean. And?

Kristin: Regarding performance, I found that during its ten-year-plus history, the fund’s return compared to the indexes was most impressive; it was almost 20 percent better than the index returns.

HE: So, it does stand apart, so to speak? What do you think, Linda?

Linda: Not so fast is what I think. When I looked more closely, I found that all of that 20 percent outperformance was attributable to returns more than five years ago. When I looked at the last three years, when current management was in place, I found that all the outperformance disappeared.

HE: Terrific. Kiran, what did you find? Kiran: I looked at tax efficiency.

HE: And?

Kiran: Throughout the last three years, there was almost a 1 percent extra tax drag on the active fund as compared to the much more tax-efficient index funds.

HE: Conclusions?

Kiran: My conclusion would be that, while the fund seems to be of decent quality, if I were making a recommendation to my client, I would recommend the exchange- traded fund.

HE: And why is that?

Kiran: Recent performance of all three funds was quite close on a pretax basis; however, on an after-tax basis the index alternatives would deliver more after-tax returns to my taxable clients. Also, with an index investment, I’m basically sure of par performance; that is, after expenses an index will consistently be in the top half of the performance universe, whereas an active manager may do well for one period but poorly the next. So, unless I find an active manager I believe can consistently outperform an index alternative, I’ll stick with the index. It’s like going out on the golf course and being guaranteed to shoot par.

HE: And the moral?

Kristin: Next time I read a glowing article about a hot shot manager, I won’t add that manager to my clients’ portfolios until I determine what sandbox the manager’s playing in, put him through the screen of the three Ps, and select an investable benchmark to compare his risk and returns to. And if it’s for a taxable account, I won’t forget to consider taxes.

Elizabeth: Professor Evensky, is this going to be on the test?

HE: Think of this as a very tough life test, Elizabeth, one that every investor has to pass more than once on the road to retirement.

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Harold Evensky is the president of Florida-based Evensky & Katz/Foldes, a fee-only financial planning firm, and an adjunct faculty member in the Texas Tech financial planning program. Harold is an internationally recognized author and speaker on investment management and financial planning topics, and has been the recipient of numerous industry awards.

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