On a talk show recently an investor commented on how disappointed he was about the performance of his Managed Global Portfolio. I won’t mention the specifics of the company involved, but suffice it to say, the investor lost money last year. Not a lot of money mind you, but enough that he was looking to make a change in his portfolio.
Another investor mistake driven by an emotional response to raw numbers viewed in a vacuum. No thought about whether the so-called poor performance was the result of bad picks by the manager (known as tracking error) or general lackluster performance in the space where the portfolio was invested (i.e. market driven performance).
I suspect this is an issue for many investors. Especially if you have been holding actively managed global or US equity mutual funds over the past year. And like the caller, you might be asking whether changes to your portfolio are warranted.
What you should be asking, is how does one approach portfolio changes? What should I do, what numbers should I examine, and when is a change warranted. The goal is to avoid making wholesale changes at exactly the wrong time.
To begin, you have to have some way to measure your manager. A benchmark that tracks the performance of the market you are invested in. That leads to 1) a review of the managers’ tracking error, 2) an evaluation to understand whether the tracking error was significant and 3), if it was… why?
Tracking Error
Investors are keenly aware that investment returns are driven to a large extent by the performance of the market. A rising tide lifts all boats. Just as a falling tide can drag down your boat.
If you are invested globally, as was the talk show investor, you probably lost money. Not necessarily because the manager was bad, but likely because large global markets (i.e. the US, EAFE, etc.) were negatively impacted by a rising Canadian dollar.
Investors who do not understand that find themselves getting caught up in the day to day hype, and making wrong decisions. Listen to the news and you hear that the US market, as measured by the S&P 500 composite index, was up 6.2% in 2007. The Nasdaq fared even better, as it was up more than 9% year over year. The Canadian market rose just over 7% as measured by the iShares S&P TSX 60 (symbol XIU). Equally positive returns, except that for Canadian investors, those returns are not reflected on the month end statements. Because the month end brokerage statement reports performance in Canadian dollar terms. Which turns those positive US numbers into negative numbers.
Longer term the Canadian dollar impact has been even more dramatic. Since January 2005, the S&P 500 Depositary Receipts (symbol SPY) which tracks 1/10th the value of the S&P 500 index, has risen 21.04% in US$ terms. When those returns are translated into Canadian dollars, SPY has declined 23.17% over the same period (see figure 1).
If you have been invested in a US equity fund over the past three years, you will have most likely lost money. The question to address is whether the manager did better or worse than a Canadian dollar equivalent investment in the US stock market.
If you examine the manager on that basis, and if after that examination, you find that the manager under-performed, then we move to phase three. Why did the manager underperform?
This is particularly relevant, because if you considering a move from one manager to another (i.e. one fund to another), you should believe that the positions the current manager has taken are not likely to pay off next year. And more importantly the positions the fund manager you are looking to move to are likely to pay off.
Suppose for example, your US fund manager held an over weighted position in US investment banks during 2007. As a result your manager underperformed the US market. Another manager, who you are looking to move to, had over weighted gold and oil during 2007, and as a result, out-performed the US market.
At this stage, your decision to move is premised on the past performance of the two managers. But here is the question, was the second manager smart, or simply lucky? If the latter, he most likely will continue to hold gold and oil.
Same thing with your current manager. Was he unlucky or just early, in terms of his investment in US banks? Suppose he wanted to continue holding the banks. The question for you to ponder, is do you think US banks or oil and gold will outperform in 2008. If the former, stay put. If the latter… move.
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