Different metrics apply to different types of money managers. Here, we'll classify money managers into four basic groups. First, index fund managers. Second, mutual fund managers. Third, venture capital and private equity investors. And fourth, hedge fund managers. Stock indexes are metrics used by investors to track the overall performance of an entire market rather than the performance of an individual stock. For example, the S&P 500 index, lookup symbol ^GSPC, aggregates the stock price performance of the 500 largest companies in the US ranked by their market capitalization. We should pause to explain that market capitalization is the current market price of one share of a companies common stock multiplied by the total number of shares of stock of that company that potentially could be bought and sold. For example, a company with a share price of $52 per share. And 5 million shares that could be traded, would have a market capitalization of $52 times $5 million or $260 million. The S&P 500 index is not a simple average of 500 stock prices. With each stock contributing 1/500th, or .2% to the total. This would be an equal weighted index. Instead, the S&P 500 index is a market-capitalization weighted index. Each company's stock price changes are weighted by how much their market-capitalization contributes to the total. For example, because Apple has a current market capitalization of $666 billion and all 500 companies together have a market capitalization of $15 trillion, then Apple stock price changes contribution to the index is weighted a 666 divided by 15,000 or 4.44% of the total. Now one very popular type of investment strategy called passive investing is to buy and hold for the long term an investment attracts the performance of an index as closely as possible. To do this for the S&P 500 index, one would buy units in State Street's SPDR S&P 500 ETF investment trust, lookup symbol SPY. SPY is a $135 billion exchange traded fund that holds shares in all 500 index stocks in exactly the proportions they have in the index. SPY was created in 1993 and is one of the most heavily traded assets in the world. Index fund managers do not need to pick stocks. They are managing a passive investment. Nevertheless, they do have a challenging job. They are constantly working to rebalance and maintain the correct ratios of each stock to match a paper index exactly while at the same time minimizing transaction costs. Index fund managers are judged on two factors. How closely their fund performance matches that of their index. And how low their expense ratio is. Most index funds track their index extremely closely. Differences of even one tenth of 1% in a year are unusual. So the primary focus in evaluating passive managers is on their expense ratio. The expense ratio is the money spent on operating the fund divided by the total market value of the fund assets. Operating costs include marketing, general and administrative expense, but mostly they're what the fund managers pay themselves. The expense ratio does not include brokerage fees the fund pays to buy and sell its assets. SPY has a current expense ratio of only 0.0945%, which sounds good until you consider that that is over $127 million paid out every year. Two more recently created competitors to the SPY, the iShares S&P 500 Exchange Trade and Fund, symbol IVV, and the Vanguard S&P 500 Exchange Trade and Fund, symbol VOO, have significantly lowered expense ratios. 0.07% and 0.05% respectively. In so called efficient markets, such as US publicly traded securities, a strategy of identifying a subset of stocks in one's universe that one's research suggests will out perform the market as a whole. Then buying and holding those stocks, almost never works over the long term. In fact, according to State Street, which markets SBY, over the past years, 80% of professional active money managers who selected their stocks from among the universe of S&P 500 stocks. And by the way, who are paid much higher fees typically than the 0.09% paid despised managers, performed worse than SPY. That's worse than random chance. If the managers pick their portfolios at random, simply weighing them by relative market capitalization, and held them, 50% of managers would outperform the index. Nevertheless, many people still choose to invest their money with so-called long only mutual fund managers. People who pick equities from a Universe. Mutual fund mangers are expected to specialize. Some of the ways that they specialize are by only buying stocks of a particular company size, by market cap, large, small, micro, are the main categories. Or in a particular market sector, such as mining, retail, or information technology. Or in a particular country or group of countries such as the BRIC, Brazil, Russian, India, China markets. The larger pool of 500 or 1,000 or more potential investments from which a manager selects the 30 or so stocks he or she chooses to hold. Is known as his or her universe. The mean return of all the stocks in his or her universe is the relevant index that becomes the benchmark for evaluating the performance of that manager. Mutual fund managers are judged primarily on three measures of how they perform relative to their benchmark. The first is excess return. So if the S&P 500 is their benchmark and it's up 8% and a manager selecting 30 S&P 500 stocks is up 12%, the manager's excess return over the benchmark is 4%. One problem with the excess return methodology is that if the S&P 500 is down 20%, a manager with an excess return of 4% over his benchmark could still be down 16%. In addition to excess return over their benchmark managers are expected not to deviate too much from their benchmark. The standard deviation of their excess returns is known as their tracking error. And it is considered undesirable to have a large tracking error. Tracking error is a kind of risk matrix. It is the standard deviation of the difference between returns of the manager's portfolio and returns of their benchmark index. The standard deviation of excess returns. The third metric which combines excess return with the tracking error is the so called information ratio. The information ratio is the excess return divided by the tracking error. >> We use the example of a market that over four years was up 25% one year, up to 10% one year, down 4% one year, and down 18% one year. >> In addition to excess return over the benchmark, managers are expected not to deviate too much from their benchmark, and we can measure the degree of deviation by measuring the standard deviation of the excess return. So let's suppose that this is the market and this is a manager. Say the manager returns 27% when the market returned 25%. 12%, minus 2% when the market returned minus 4%. And minus 23% when the market returned minus 18%. So, our excess returns would be 2%, 2%, 2% and minus 5%. Okay. In this case we would take the standard deviation of the excess returns and this would give us a value of 3.03% which is known as the tracking error. Okay, a third metric combines excess returns with the tracking error. It's the so-called information ratio. So, if we look at the geometric mean return of the manager over these four years, it's an annual return that exceeds the market return by 1.79%. So we have 1.79% excess return over the four years annualized. Divided by the tracking error of 3.03%. And this will give us an information ratio, or IR of .59. An alternative approach to evaluating active equity managers. One that, in my opinion, makes a great deal of sense, is to look at their Sharpe ratio and in particular, their Sharpe ratio compared to the Sharpe ratio of their benchmark. For example. Suppose that the S&P 500 index returns 12% over a 5 year period with a volatility of returns of 14%. We can plot this on our standard chart at x axis equals 14%, y axis equals 12%. Okay. Now we want to compare that to a money manager who returned 17% per year. So, initially it sounds like that manager returned 5% per year more than the S&P 500, so that sounds good. However, when we look at that manager's volatility of return, it turns out that they had a volatility of returns of 25%. So to plot on our standard chart we would have a position of 25% and 17%. Now let's suppose that over the time interval that we were talking about, there was a risk free rate of 2%. What we would quickly see. Is that, simply using the passive index investment, but increasing leverage by borrowing money to buy the index would have outperformed money managing. The slope of the line is clearly less. S&P return 10% more than the risk free rate of the annual volatility of 14% so the slope of that line is 10% over 14% equals .714 and the integers return and her slope was significantly less. Their sharp ratio would be 15%. Divide it by 25%, or .6. We could have achieved the same 15% excess return, with a volatility of only 21% by simply buying the passive index fund and paying for one third of it with borrowed money. And that would put us somewhere right about here. In order for an active manager to outperform a passive index fund, they must maintain a higher Sharpe ratio than the index Sharpe ratio.
