The standard risk warning that you will see on all financial literature is that ''past performance is not indicative of future returns'. But are there more reliable measures to use when choosing a unit trust or investment trust?.
While there are various fund ratings systems out there which aim to rank a fund manager's performance they are seldom objective. Yet, there are a number of readily available objective fund statistics (trustnet.com is one source) which can give you an insight into a manager's performance as well as the amount of risk they are taking with your savings. Below I list five of the most important and how to use them:
- Alpha- In simple terms alpha is a figure which measures a manager’s apparent skill at picking the right investment opportunities. So a fund with a positive alpha shows that the manager is obviously doing something right as he’s generating returns ahead of what you would expect, given the returns of the wider market. The higher the alpha figure the better. A positive alpha of 1% means the fund has outperformed its benchmark by 1%. Similarly, a negative alpha of -1% would indicate an underperformance of 1%.
- Beta - Beta measures a fund’s sensitivity to the general market in which it operates. The market always has a beta of 1 by definition. So if a fund also has a beta of 1 that would mean that if the market rose by 5% then so should the fund. If the fund has a beta of -1 then as the market rises so the fund falls. A well-managed index fund will have a beta of exactly 1. Funds that outperform the market when it does well but do even worse when the market is going down will have a beta above 1.
- Volatility (standard deviation) – The standard deviation shows how widely a fund’s return varies from its benchmark over a given period. A fund whose annual return hasn’t differed much from its long-term average return will have a low standard deviation and has therefore displayed a lower volatility of returns. If a fund has an average annual return of 10% but a volatility of 15%, this means that the range of returns has varied from -5% to +25%. High volatility obviously could give rise to higher returns but also higher losses. So compare a fund’s volatility to other similar funds within its sector and make sure you are happy with the level of volatility as this is indicative of the level of investment risk you are taking. Also have a look at the fund's sharpe ratio.
- Sharpe ratio - The sharpe ratio indicates how much excess return the manager has produced for the increase in volatility, as a result of holding riskier assets. Remember, volatility is not in itself a bad thing as long as the excess risk is rewarded by improved returns. The higher the sharpe ratio the better.
- R-Squared -gives a measure of how much of a fund’s movements can be attributed to a movement in the fund’s benchmark. A high R- squared figure (0.85-1) would suggest that the fund’s performance patterns have been in line with the fund’s chosen index. A low R- squared (under 0.7) suggests the opposite. R-squared also sheds light on whether the benchmark against which the fund is set against is actually relevant. A low R-squared would suggest the benchmark and therefore the Beta measure, explained above, is irrelevant. But if a fund has a Beta less than 1 and an R-Squared close to 1 this would suggest that it is offering high risk-adjusted returns, which is a good thing. This is because the fund is capturing the returns of the general market (the R-squared bit) but is less sensitive to market movements up or down (the BETA part).