Different managers follow different styles and approaches.  By implication, their portfolios carry different levels of risk.  The common wisdom at present is to compare manager performance using the “Sharpe Ratio” which compares the return generated per unit of risk taken.  This approach is erroneous.  The measure of risk used in the calculation of Sharpe Ratio is portfolio return volatility.  However, risk is probability of capital loss; volatility does not equate to risk. 

We believe clients should measure manager performance through multiple ways

1. Measure against the stated objectives/mandate: What role is the manager playing for you – Absolute return? Discovery of next generation leaders? Steady returns above the market?
2. Measure against a market index – best low cost substitute; Measure over a time horizon that will permit comparison across a cycle – ideally at-least 5 years. 
3. Measure post tax and post fees

Measure against stated objectives

Clients have very different needs and risk profiles

• The most conservative client we have had never invested in Equities before.  They are taking a first step.  Any return, superior to 6% post-tax is a strong improvement on their existing returns through a 100% FDs and Bonds portfolio.
• Our most aggressive client had a portfolio which has always been 100% Equities and where the top 2 stocks in his portfolio were 65% of his portfolio.    We suggested they tone down their Asset Allocation to Equities and hold some money in Bonds for Optionality; additionally, we recommended portfolio diversification where top 2 stocks were no more than 30% of the portfolio. 

Each of the above objectives will result in a compromise – Consider the following examples

1. For the conservative client, for portion allocated to equity, we have built a portfolio of blue-chip stocks which have a very low probability of Capital loss over 3 years, and have a high dividend yield.  Portfolio composition may not have companies who are growing very quickly but where business models are not mature. 
2. For the aggressive client, a key objective alongside growth is to de risk the portfolio.  The de risked portfolio may underperform the “as is” portfolio.  However, de-risking is probably the right thing to do as it lowers the probability of significant capital loss due to unforeseen risk associated with 2 dominant positions
3. In both the above scenarios, it would be unfair for the client to forget the brief/mandate and post 3 years, compare our performance against other Managers who could be executing unconstrained mandates

Measure against a market index and other managers ONLY if everyone has a common brief – “Unconstrained investing”

If you have a similar brief to managers, the best way to measure performance is against a large Index and over long periods of time.  The Index is a low-cost substitute to actively managed funds and any fund manager charging management fees should outperformance the Index post fees and post any taxes. 

A long time period is critical – preferably one that includes a significant market up and down move.  Buffet quips that “only when the tide goes out does one realize who is swimming naked”.  He was not being academic – The Mutual Fund that was the highest performing fund in India in CY 2007 lost approx. 80% of its NAV in CY 2008.   During times of excess, the riskiest business models are the glitziest… hence, it’s important to ensure that performance comparison across managers covers an entire cycle. 

Measure post-tax and post fees

Different strategies have different transaction costs and tax implications.  A “long short” strategy or “trading” strategy would be fully taxable in India while a buy and hold strategy would be tax-free if the portfolio is held over a year. To have the same post-tax returns, the long-short strategy would need to deliver over 50% higher returns (@ 33% tax rate). Similarly, a strategy of frequent trading would not only have a 33% tax outgo but also have much higher brokerage costs which would reduce the NAV.

Fund manager fees should also be deducted from the NAV to arrive at money in client pockets. 

Summary

The fund management industry is a marketing machine with a lot of spin. Insecurity associated with churn/loss of AUM, creates a vicious cycle of jargon and misleading performance statistics. Lack of trust, a short term outlook and unaligned incentives are the core root causes. 

Investors should ensure there is alignment on objectives at the start of the process, and documentation on the approach managers will follow to deliver on those objectives and how performance will be measured. They should also appreciate that there is no holy grail … no one strategy works all the time.   Hence, no fund manager can be expected to outperform every other manager at all times.  Investors also need to keep a long term outlook; anything less than 3 years, preferably 5 years, is too small a period to evaluate performance.  Fund managers should ensure their clients understand the approach they are following and there is alignment on objectives/incentives.  Those who bank on a good investment process, will surely deliver good results.  Results supported by trust and aligned incentives will ensure customer loyalty