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Measuring performance for all types of fund managers

In thinking about expert investing communities like Covestor and Kaching, one of the main concerns users/investors should have is in how to judge performance of stock-jockeys.  These communities, which allow pretty much anyone to set up a portfolio and for others to piggyback on top of them by watching every move, suffer from a similar problem that also plagues the more traditional, button-down mutual fund industry.

And that is, how to judge performance results.

In speaking with my business partner recently about expert investment communities, he kept expressing a worry about just who these portfolio managers are.  At least with mutual funds, we can be relatively sure that the person managing our portfolios is qualified to do so and will probably — probably — hit close to his benchmark +/- every year.  You don’t know anything about the stock jockeys behind these online communities other than their metrics.  We rely upon the investment industry to effectively vet participants.  Is 1-yr performance enough to judge someone online?  He has a point.

So, how to measure performance and compare managers?

Here, investors are frequently on their own.  Most of the time, we see a given mutual fund’s performance relative to that of an index.  But the dirty little secret in the mutual fund industry is that funds typically look for the most favorable index.  And that can change yearly depending on performance.

With the explosion of ETFs based on new proprietary indices — some of them centered around minutae (I’m thinking the European, Ex-Germany Nanotechnology Index, or something), these comparisons mean less and less.

Risk metrics don’t quite cut it

To counter this, many mutual funds or comparison websites use risk metrics like “beta” or the “Sharpe Ratio”.  Unfortunately, most investors don’t know what these terms mean or how to judge them.  More education and less jargon is for sure needed here.  Opportunity?

Well, expert communities are not lying down and taking this lightly.  They do have the mutual fund industry in their sights and want to compete where they think they have an opportunity.  One such opportunity, as told to me recently by Dan Carroll, CEO and co-founder of Kaching, is by attacking the opacity of mutual funds.  Investors in mutual funds don’t really know what they own, why the managers are choosing such stocks as part of the portfolio, and why it should boost performance growth. And more so, they don’t have or understand the tools to judge investing competency (ie, how much of your mutual fund performance can be attributed to luck?  Anyone?  Bueller?).

To protect our investing community, the mutual fund industry and the regulatory regime behind it has made a certain expression so memorable:

“Past returns are not indicative of future performance.”

Why?  If a manager is truly gifted, shouldn’t we see in his returns his ability to outperform.  And if we can’t, either because of mean reversion or lack of a hot-hand, shouldn’t we all be in passively managed mutual funds or ETFs?  Hedge Fund managers would dispute

Kaching’s Investing IQ

To counter, Kaching has developed what it calls the Investing IQ. According to the company:

So how do the pros pick investment managers?  To answer that question, we turned to the best, the managers of the Ivy League endowment funds.  Between them, these managers oversee more than $100 Billion, so they’d better pick right.

When picking investment managers, the premier endowments look for three things:

1. Great risk-adjusted returns
2. Compelling investment rationale
3. Adherence to a stated investment style and preference

So, come later this year when Kaching allows users to hook up their trading accounts to Kaching’s platform to mirror their accounts to the trading activities of Kaching’s top participants, users will use Kaching’s Investing IQ to size up these prospective managers.

More specifically,

[Investing IQ] consists of the same 3 components as the qualities the Ivy managers look for:

1. Risk adjusted returns- based on an investor’s information ratio
2. Quality of rationale – based on the kaChing community’s ratings of an investor’s research
3. Sticks to Strategy – based on an analysis of how an investor made his returns

Basically, it makes sense.  We want to invest in the best performing manager at a particular risk level that matches ours, one who is the most analytical in his analysis and whose activities match best what he’s set out to do.  If a deep value portfolio manager makes his gains in Google, well, that’s not exactly what we’ve entrusted him to do.

Covestor’s performance-driven approach

Covestor seems to take a different tack and focuses more on performance and risk.  This expert investing community uses Time-Weighted Returns.  According to the firm:

As opposed to being the absolute % cash return that the lead member realizes, the Time Weighted return figure is designed to reflect what someone would achieve if they invested a fixed amount alongside that member. In other words even if the leader adds or removes cash from their account, the portfolio of the follower simply rebalances to reflect these changes (rather than increasing or decreasing in size as that of the leader does).

Ever wonder why your returns don’t reflect whatever the mutual fund company says the returns should be? Because it reflects exactly what investors would see in their accounts if they were to simply mirror a portfolio without putting money in and out as a fund manager might, Covestor thinks this metric is really important because it’s

more valuable to other members following you, in showing what they can truly achieve. Our job is to put you on a level playing field with the so called ‘pros’ and so many of you are doing such a great job we can’t wait to turn the ‘return’ figure into a reality for your following.

From my vantage point, it looks to me like Covestor plays right into the sweet spot of the mutual fund industry: pairing up hot money with outperforming mutual funds.  There is a large clutch of mutual fund investors who believe in a strategy of investing in the top performing mutual funds in order to ride their momentum. In going toe-to-toe with the mutual fund industry, Covestor’s Investing Darwinism will over-weight current performance.  You have to really walk the walk to play or sit the heck down.

The real money test

With a strong focus on performance, Covestor is the American Idol of money management.  With a different vetting approach, Kaching is more like the American Gladiator of running money.  When either of these systems enable real money to be put to work, it’s going to be interesting how this plays out.

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Additional Resources:

• Kaching
• Covestor
• More New Rules on expert communities

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