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Want to Test Your Managers' Mettle? Ask Them to Work Backward

Don't settle for reassurances. Ask active fund managers to explain how they'll deliver the value they purport to add after fees.

Suppose you're being pitched an active fund. It'll typically go something like "We'll deliver superior returns but without more risk" or "We'll protect the downside but without forgoing any returns." True, a manager or fund firm might not choose those exact words (there are rules and regulations to be complied with, after all), but the meaning is clear: You'll get something but won't have to give up the same amount.

How should you, as an investor, test that assertion? You can do gobs and gobs of fundamental research to arrive at a conclusion, sure. But that takes time and resolve that you might not have. Plus, it puts the onus on you to test an assertion that has gone unmet far more often than it's been fulfilled by active funds over time. Instead, turn it around. Say to that manager, "Ok, cool, explain how you'll do that, working backward."

Getting to 'How' Here's what I mean: We can re-express a portfolio manager's assertion in numeric terms. For the sake of this piece, let's use the information ratio as that numeric measure. The information ratio compares a security's excess returns (measured versus a specified benchmark) against its tracking error (the standard deviation of differences between its returns and its benchmark's). It takes the following form:

Information Ratio = Security Return – Benchmark Return / Tracking Error of Security Return

The higher the information ratio, the more value that security has delivered per unit of risk, and vice versa when the information ratio is negative.

So, let's imagine we're looking at an active U.S. stock mutual fund. While any information ratio we choose is going to be arbitrary by definition, let's go with 0.20. That figure roughly approximates the 25th percentile information ratio of surviving U.S. equity funds over the 20 years ended July 31, 2019, as shown below.

Source: Morningstar.

That's one piece of the equation, but we need another--tracking error. As the scatterplot below makes plain, there's no ironclad relationship between information ratio and tracking error. Some funds have excelled by zigging when their benchmark zags, while others have languished while moving in lock step with it. The median tracking error of these funds has been around 6.5% per year, but let's assume that our fund is going to run a bit hotter at 7%.

Source: Morningstar.

Work Backward With these assumptions we can ask our manager to work backward. How so? Well, for our fund to generate a 0.20 information ratio with 7% tracking error, it will have to produce 1.40% of annual excess returns after fees. If this fund levies 75 basis points in annual expenses, that means the fund is going to have to top its benchmark by around 2.15% per year.

The question for the manager: Where is that 2.15% excess return going to come from? The portfolio manager ought to be able to decompose it into its constituent parts--for instance, "We expect the bulk to come from multiple expansion, a lesser amount from earnings growth, and a little bit from dividends," or a variation thereof. The manager also should be able to explain from where in the portfolio that outperformance is likely to originate.

Push, Pull, and Portfolio Management Remember, after all, the portfolio holdings aren't going to deliver this outperformance in unison. Rather, it'll be a push-pull, with one part of the portfolio propelling the fund ahead of the benchmark and another part dragging it behind. This means, in aggregate, the portfolio's winners will have to generate more than 2.15% of excess returns before fees.

To put this in perspective, one of the best-performing funds of the past few decades, Vanguard Capital Opportunity VHCOX, saw positive contributions from around two thirds of the 400-plus stocks it held at some point over that span. In other words, one of the very best funds still failed around a third of the time. (Note: Its winners contributed about 10 times more to performance than its losers detracted.) Most funds won't hit for this kind of high average, though, making it paramount that they bag enough big winners.

Is it conceivable for an active stock manager to ride a few "multibaggers" to outperformance? Yes, but it's not especially likely, making it important to ask the manager to explain how stock selection and portfolio construction lead to realizing such outcomes. For instance, does the fund concentrate its holdings? What is the typical holding period? Why would the stock double or triple from here, and is that thesis reconcilable with the manager's stated process? And does this overall portfolio-management approach seem compatible with the 7% tracking-error budget mentioned in our hypothetical scenario?

Testing the Fee This process can useful in another way: It can offer a sense of whether the manager and fund company have been thoughtful in setting the fund's fee. If an active fund is charging, say, 1% a year, then the manager ought to be able to explain where at least 100 basis points of pre-fee value is coming from. Absent that, there's really no point investing in the strategy.

This can be revealing, yielding insights into whether management has set the fund's expenses based on what it believes it can deliver to investors before fees, or--as is often the case--relative to what the competition is charging. If it's the latter, then it could indicate the manager and fund company haven't been as rigorous in structuring the process for success as they could have.

Conclusion The burden of proof in active investing rests with the managers. With that in mind, it can be helpful to ask them to work backward. Even if you don't have the opportunity to sit down across the table from the portfolio manager, a framework like this can still be useful in sharpening your own thinking around the sources of outperformance and the likelihood of a fund overcoming its fee hurdle. Most active funds won't be able to clear that hurdle and, thus, working backward can be valuable in weeding those out.

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