Saturday, April 27, 2013

Alpha, Beta, Sharpe and the Value of Advice and Supervision

When one is considering investment options, it is sometimes difficult to see through the clutter of sometimes conflicting information.  In many financial publications, a buy/hold “passive” approach to investing is promoted. The advice is “Buy an Index Fund—Active Managers never beat the market over the long term”. Or alternatively, “Seek out investments with the lowest fees—fees always reduce your potential return.”

The problem with such advice is that it is wrong—but not completely.  Fees can reduce potential returns—UNLESS the benefits from the activities of the Active Manager exceed the costs. There are many Active Managers who try but never do beat the market—but there are also many “better than average” Active Managers who do in fact provide performance that beats the chosen benchmark, risk management considered.

When choosing investment options, the “right” choice depends on many factors.  Benefits and costs should both be carefully considered and weighed in the balance.

What many people that write for financial publications fail to tell you is that investing needs to consider returns AND risk.

For example, many Active Managers intentionally hold cash in reserve and “trail the market” during a rising market because they are “managing risk” to avoid or reduce the effects of market declines.  And, what people fail to realize is that index funds are a bit like flying on auto pilot—OK when markets are rising—but a bit scary during a stormy market decline.

Generally, the discussion about Active Managers and Index Funds relates to mutual funds—the favored investment for the mass market. But a similar analysis would apply to the more customized approach of a fee-based Investment Adviser managing your own “customized” investment portfolio.  Benefits and costs should both be carefully considered and weighed in the balance.

The tools needed to evaluate the benefits provided by a fee-based Investment Adviser are both quantitative and qualitative:  Is he trustworthy and diligent?  Is he skilled and experienced?  Does he possess the required educational credentials?   The quantitative metrics should be expanded to include measures of performance and risk together rather than just performance. 

The “Big Three” risk/reward or metrics I think are the most useful are: Alpha, Beta and Sharpe Ratio.

Alpha is a measure of performance on a risk-adjusted basis. The excess return of the investment relative to the return of the benchmark index is a fund's alpha.  A positive alpha of 1.0 means portfolio has outperformed its benchmark index by 1%.

Beta is a measure of the volatility. Generally the lower the beta, the lower the risk associated with market fluctuation as compared to the benchmark.

Sharpe Ratio is a measure of return for a given level of risk as compared to the benchmark. When comparing two assets versus a common benchmark, the one with a higher Sharpe ratio provides better return for the same risk (or, equivalently, the same return for lower risk).

Lets do some comparisons:

Vanguard’s unmanaged 500 Index Fund: 124% 10 year return (All stocks); Alpha=0; Beta=1.0; Sharpe Ratio= 0.52   (Worst one year decline was 43%!)

American Funds popular Capital Income Builder (25-40% fixed income):  125% 10 year return (116% with max commission); Alpha=0; Beta=0.67; Sharpe Ratio=0.68. (Less volatility than the index fund, better return vs risk ratio. Worst one year decline was 34%.)

Legg Mason Value: 43% 10 year return (All stocks); Alpha=Negative 5; Beta=1.28; Sharpe Ratio=0.2 (Worst one year decline was 59%!)

So, Capital Income Builder was a good value in that the return was close to the benchmark index with much less risk. Legg Mason’s Value fund was a poor performer—better to have bought the index.

Now, lets look as some “Custom Managed” Portfolio’s:

Highly diversified $1 million + account “conventional” program, composite with “value” orientation (30-35% fixed income): 126% 10 year hypothetical return (116% after fees)  Alpha=0; Beta=0.55; Sharpe Ratio: 0.78. (Less volatility than Capital Income Builder, better return vs risk ratio. Worst one year decline was 27%.)

Highly diversified, actively managed with high intensity, composite with “value” orientation (15-20% fixed income incl cash):  250%+ 10 year hypothetical return after fees; Alpha=6; Beta=0.8; Sharpe Ratio=0.78.  (Less volatility than benchmark index, very high return vs risk ratio. Worst one year decline was 27%.)

So, the Investment Adviser in this case provided his clients with the choice of a lower risk portfolio with returns close to the benchmark index. (Risk management for essentially little or no net cost) Or, at the other end of the spectrum, with higher risk (but still lower than the benchmark index) with returns far in excess of the benchmark.  In this example, the actively managed with high intensity portfolio would have hypothetically grown from $100,000 in 2003 to $350,000 (after fees) in 2013 compared to only $225,000 if invested in the unmanaged index fund or the “better than average” managed mutual fund.   

The value of advice with continuous and regular supervision by an experienced manager?    Certainly more than the cost of the fees in most cases… It depends on who you choose.

Choose your Investment Adviser based on his diligence, investment style and philosophy, education, experience, and judgment. Keep in mind that it’s difficult to judge past performance without looking at more than five year periods of time—and judging probable future performance is more important. Look out the windshield, not the rear view mirror. Choose wisely and you will be well rewarded with good long run returns and peace of mind.