How do you rate the performance of fund managers in such a way that investors can see the risk level that is being taken and the consistency of the returns being delivered?
RiskMetrics Group, the New York-based analytics company, thinks it has found a way. The firm has launched "Best and Worst" - an evaluation of mutual funds and investment trusts in the US and UK that ranks the best and worst performers in managing risk and delivering returns over an extended period.
"What we are showing, in a purely quantitative way, is which funds have outperformed, on a risk-adjusted basis, over a five year period with the greatest amount of consistency in performance," says RiskMetrics' market strategist Michael Thompson.
He says other fund ranking systems set too much store by primitive return analysis - such as straight-line average - and often include a qualitative factor that should be irrelevant to investors.
"There is often a qualitative fudge factor - people saying things like 'we like this fund because we like the manager'," says Thompson. "Why? Does he pick a good tie or a good restaurant or something? Either the fund performs or it doesn't. I'm puzzled by that kind of approach."
RiskMetrics' CEO Ethan Berman says the new evaluation system - which Thompson describes as "a Sharpe ratio with a vega slapped on top of it" - allows investors to "separate fund managers who govern risk from those who are erratic".
The evaluations - which cover all publicly traded funds in the US and UK - are assigned within four categories of risk profile: conservative, balanced, growth and aggressive. The best and worst in each category are those that fall in the top and bottom standard deviations.
This could be a single fund, as in the each of the best and worst conservative funds in the US - Vanguard/Wellesley Income Fund and Gabelli Mathers Fund respectively, according to RiskMetrics.
Or, at the other extreme, it could be a whole host of funds: 23 in the case of best growth fund in the UK, or 38 and 39 respectively in the categories of best and worst aggressive fund in the US.
The system does not show returns over any time period. It does not pretend to offer any predictive analysis. And, the firm says, its analysis should be used with other ratings to deliver an all-round assessment.
Pay attention
Adjusting for risk and rewarding consistency should help investors to identify those funds that have performed well simply because of the market and those that are taking risks beyond their stated levels.
"Investors should pay less attention to what a fund calls itself and more attention to what kind of risks the fund is taking," says Thompson. "They are likely to be more successful thinking in terms of risk allocation than asset allocation."
He adds: "Would you rather be in a fund that has had two spectacular years, but crapped out in the previous three, or a Steady Eddie?"