Mutual Funds: Know Where the Risks Lie

In the wake of the Bernard Madoff scandal, investors need to understand how mutual funds make their returns and what the risks are
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As the alleged Ponzi scheme run by money manager Bernard Madoff has made clear in recent days, people put their money into "black box" investment strategies at tremendous risk. The scandal underscores the need for investors to have access to more information about how their returns are generated.

Performance measurement and attribution systems, as the most sophisticated of these tools are called, account for a growing niche within the business technology sector. Thomson Reuters (TRI), StatPro (SOG.L), and SS&C Technologies are the top three providers of installed standalone software systems used by pension fund sponsors, endowments, and other institutional investors, and a growing number of smaller boutique firms now offer similar tools, according to a September 2008 report by the Aite Group, an independent research firm in Boston. Retail investors have little need for the specialized information these software platforms provide, but some of the data could help them decide which mutual funds to invest in.

Some market professionals believe the bear market has increased investors' desire to identify where a fund's returns come from now that gains are harder to come by. David Spaulding, president of the Spaulding Group, a money-management consulting firm in Somerset, N.J., and a leading provider of training in performance measurement, says these tools have become more important over the past decade as part of the natural desire for as much information as possible. And while the concept of attribution—which distinguishes returns due to asset allocation from returns due to stock selection, currency effects, and other factors—goes back nearly 40 years, the technology that supports it has been available for only 10 to 15 years, he says.

Predicting Returns

Spaulding says attribution becomes more important when managers try to explain losses to their clients. "We know of cases where managers will sit down with clients and say, 'We had a bad year, but I know why it happened, and this is what we're doing to correct that,'" he says. "That ability clearly has value. It gives the client some confidence in the manager that he has his finger on the pulse [of the market] and is taking corrective action."

Philip Silitschanu, senior analyst at the Aite Group, notes a trend over the past two to three years to use newer performance measurement and attribution systems not just as a reporting tool but also as a way to predict future returns. Martin Gruber, a pioneer of mutual fund research and a finance professor at New York University's Stern School of Business, believes investors can study how certain fund styles have performed over time. But he believes that it's easier to predict a fund's negative returns than positive returns based on past performance. "Bad managers tend to stay bad managers," he says. "Good managers tend to a lesser extent to stay good managers."

One of the most basic things an investor needs to understand when it comes to investing in mutual funds is a 30% positive return in any year may not actually be the investor's return, because it depends on when he put money into the fund. The timing of investors' contributions and redemptions affects their returns. For example, if a fund's net asset value goes from $10 to $20 per share, and at that point money pours in from new investors, and the NAV then settles back to $13, those people who invested money when the NAV was $20 may have lost some money. But the portfolio manager will still report a 30% return because the fund's value rose from $10 to $13, says Spaulding.

"This is the biggest challenge for a lot of investors, even the more sophisticated ones," to understand, he says. "The manager can't control the timing of those [cash] flows. We decided 40 years ago to use a calculation that eliminates their effect."

Customizing Return Data

To address this, some mutual funds now report something called a personal rate of return, which adjusts for the timing of cash flows. Providing that measure requires a different calculation based on an internal rate of return, or money-weighted rate of return. While Spaulding estimates that fewer than 10% of all mutual funds provide this personalized return, there's growing interest in it, and he believes it will become more common in the future., the least expensive (and most oriented to retail investors) of the three software systems Morningstar (MORN) offers, calculates its own money-weighted returns for most mutual funds. That feature takes into account when an investor bought into and sold a fund.

More than cost, a key reason more fund managers don't provide money-weighted returns is the time required to calculate them for each of the fund's investors, says Spaulding. Another hurdle is that most fund managers don't want to have to educate investors who might be confused by and skeptical of a second return number.

More broker-dealers for separately managed accounts, however, are starting to provide individual returns on portfolios, he says. "Most of them have seen they have to give [their clients] money-weighted returns, because clients want to take cash flow into consideration," he says. "We want to tell the client how he is doing. Performance in general has become a much, much more important tool."

Being Aware of Risk

As keen as investors are to assess a mutual fund's performance, most fail to consider another very important feature: risk. Paying more attention to risk could have saved investors in Bernard Madoff's hedge fund a lot of money, because there were early signs, for those who pay attention, that something was amiss, says Spaulding. Madoff's fund "had no volatility, and volatility is one definition of risk. That's unheard of," he says. "Most investors don't give much thought to risk, but they should. They incur all kinds of risk once they decide to put money in the market."

Ken Rilander, portfolio manager at New York's Basic Value Asset Management, says the best tool to gauge risk in a security is premium software that uses regression analysis to measure how much a mutual fund outperforms or underperforms the closest benchmark index over a given period. For example, you might find that a certain large-cap blend fund is up 12% over a certain period, compared with a 10% gain by the S&P 500 index. The fund's 20% outperformance translates to an upside market "capture" of 1.2 times the index. Then you see that when the index fell 10%, the fund was down 11.2%. The fund's 12% underperformance would equate to a downside market capture of 1.12 times the index. This kind of analysis tells a money manager that a particular fund is more volatile than the benchmark but has greater ability to outperform than underperform the index.

"You want to invest with a manager that has more upside capture than downside capture," says Rilander. "We look at the ratio of the two. If that ratio isn't above one, it isn't a fund we look at. It's not just an initial selection process. You have to continually monitor this."

Style Drift

Now is an excellent time to look at risk-adjusted returns, because of the big decline in equity values worldwide over the past year, he says. But since markets were chiefly on a bull run from late 2002 to late 2007, a good measure to use today, he suggests, would be a three-year analysis of upside and downside market capture. Knowing the ratio between the two measures gives investors a better sense of the underlying risk they're taking on when they invest in a given fund, he says. This kind of analysis is also based on an assumption that the fund's managers remain the same in the future and that their investing style doesn't change.

Quite often, however, a fund's investing style does change over time—without the fund managers even being aware of it. "Managers fall in love with issues. They drift because they're buying securities rather than keeping their eye on a style," says Gruber at the Stern School. "These tools are for a manager to check whether his style is drifting."

Growth stocks eventually mature and lose their edge, but a so-called growth-style manager might have become so comfortable with a stock that he'll continue to include it in his portfolio, whether it's still growing or not, he says. Return-based style analysis shows how much of your return is coming from a particular style, and once you take that out, what's left is the contribution from stock selection. This way, you can see the contribution of each style element and what portion is coming from small stocks vs. large ones. But Gruber says he doesn't have any hands-on experience gauging how much currency moves contribute to a fund's returns.

Financial advisers such as Marc Schindler, president of Pivot Point Advisors in Bellaire, Tex., guard against style drift because they have to make sure a fund selected for a certain investment style continues to contribute its piece to a diversified asset allocation strategy. Schindler is wary of funds that outperform in the short term by chasing the highest-performing stocks, because he expects inevitable losses once those gains evaporate and the fund performs in line with its peers.

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