Analytics

Lost in the mutual funds maze? Try the FundScope Way

Manager Value-Added: a recipe for success

Mutual Fund Reports: new and updated

Tax-Smart Investing: Portfolio Diagnostics as a tax planning tool

Family Affairs: check out the sponsor before you buy the fund.

Outside the Box: If you read the articles featured in this section, you will never look at mutual funds the same way again.

THE FUNDSCOPE WAY

Note: the following reading is an advanced analysis of risk-adjusted return intended for serious investors who manage their own portfolio, or their advisors. If you take your time reading carefully, you will never approach mutual funds performance the same way again.

THE GUIDING PRINCIPLES

The FundScope way is based on three guiding principles:

First, investors should be aware of how much risk they take and should be comfortable with it.

Second, investors should be adequately compensated for risk.

Third, to measure investment success, you need a relevant benchmark that compares apples to apples.

We cannot tell you how much return your funds will deliver next year, but we can measure, with a fair degree of confidence, how much risk you are taking. Bull markets and bear markets will always come and go, so risk is inevitable. Thus the easiest way to make money in the long-term is to cut your losses during bear markets.

This is why your first priority is to manage your portfolio risk. Once you take care of that side of the coin, the other side, i.e. return, will take care of itself.

HOW WE DO IT

The FundScope way can be summarized in one sentence: tell us how much risk you can afford to take, we will show you how to design a portfolio that beats the market, both in good and bad times.

The process starts with your completion of our Asset Allocation Questionnaire, which tells us, among other things, what type of investor you are and how much risk you are prepared to take.

The second step consists of selecting the winners. By winners, we do not mean last year's hot funds which risk becoming this year's losers. We mean funds with reasonable cost, where managers have added value from active portfolio management. We refer to this factor as the Manager Value-Added factor (MVA). All FundScope Honour Roll funds have, among other things, reasonable cost and a positive MVA. Funds with positive MVA are also referred to as risk-efficient funds.

The third step is to put it all together, by building a diversified portfolio of risk-efficient funds, using Portfolio Diagnostics. If you stick to risk-efficient funds, you maximize the probability of beating a similar portfolio made of index funds (call it the Index Fund Portfolio).

The beauty of our Portfolio Diagnostics tool is that it shows you, at a glance, how much risk you are taking with each portfolio combination (no other web tool that we know of can do that for you). Therefore, you can keep trying to add and delete funds until you reach the optimal combination that maximizes return for a given risk level.

HOW TO MEASURE SUCCESS

To evaluate their investment choices, most investors compare their mutual fund results to index funds. More often than not (particularly in bull markets), they find that their funds have lagged the index, so they start blaming themselves (or their advisors). In our view, those investors are comparing apples to oranges.

Obviously, index funds are an appropriate benchmark, provided you look at both sides of the coin, i.e. risk and return. Looking at the return side of the equation is like reading half the story. It's misleading and it could prompt you to reach false conclusions or make wrong choices. The following table, entitled How to Measure Sucess, illustrates our point with a simple example.

HOW TO MEASURE SUCCESS

Risk
Model Portfolio Risk	1.42%
Peer Group Risk	1.80%
Index Portfolio Risk	2.11%
Return
Model Portfolio Return	6.18%
Peer Group Return	5.09%
Index Portfolio Risk-Adjusted Return	5.37%
Manager Value-Added
Model Portfolio Risk-Adjusted Return	7.80%
Index Portfolio Return	6.60%
Manager Value-Added	1.20%

Suppose that the asset allocation model tells you that you belong to the Income & Growth (or Balanced) category of investors. We associate this category with a moderate risk tolerance, ranging between 1.15% and 1.45% (using standard deviation as a risk measure). How to Measure Success shows you, among other things, the results of a suitable model portfolio that meets your requirement of a maximum standard deviation of 1.45%.

The model portfolio is made of risk efficient, actively managed funds. In this particular example, its asset allocation consists of money market funds (15%), one investment-grade bond fund (15%), one high-yield bond fund (25%) and two equity funds (45%).

The alternative, obviously, is to build a portfolio with a similar asset allocation, made of index funds (Index Fund Portfolio). However, if you want your Index Fund Portfolio to meet your maximum risk target of 1.45%, you have to make it less aggressive (this is normal because, by definition, index funds have a higher risk than actively managed funds).

To reduce the risk of your Index Fund Portfolio, you must decrease the percentage allocated to equity funds and increase the percentage allocated to cash or money market funds. But once you do that, the return of your Index Fund Portfolio will decrease, in this case from 6.6% to 5.37%. The table refers to this lower return as the Risk-Adjsuted Index Portfolio Return. It's the most appropriate benchmark for measuring your investment success, because it compares apples to apples. It shows you the results of each portfolio, assuming an equal risk level. In this particular case, it leads you to conclude, rightfully so, that when you reduce the leverage of your Index Fund Portfolio to reach the required risk level, its return will look much less impressive than you first thought.

The third section of HOW TO MEASURE SUCCESS, entitled Manager Value-Added, shows you the same thing, from a different perspective. Assume that, upon further thought, you decided that the 2.1% risk of the Index Fund Portfolio is not that high after all and that you can live with it. Your first reaction would probably be to opt for the Index Fund portfolio, in order to reap the higher return. But that's not necessarily a good idea.

If you really think that a 2.1% portfolio risk is acceptable, you should stick to the same funds that belong to the model portfolio. However, you can make the asset allocation of that portfolio more aggressive, to increase its risk to 2.1% (you can do that by increasing the percentage allocated to bonds and equities and reducing the percentage allocated to money market). If you do just that, you will observe that your Model Portfolio Return will increase to 7.8%. The table refers to this number as the Model Portfolio Risk-Adjusted Return. It exceeds the Index Portfolio Return by 1.2%(the 1.2% excess is referred to as Manager Value-Added). Again, assuming equal risk levels, the model portfolio is far superior to the Index fund portfolio.

You can apply this strategy and generate HOW TO MEASURE SUCCESS for your own personal investments if you subscribe to FundScope