Buying the fund that will perform best in the next period is not the same thing as buying the fund that had the highest return in the last period, whether the period is one year or five years. If this were not so, there would be no need for consultants. The way consultants add value is to adjust the raw returns in a way that makes it possible for investors to make informed decisions about their choices. The omega returns shown here are adjusted for:
the risk associated with a given style of management;
the amount of risk the fund takes relative to the style; and
the average investor's degree of risk aversion.
The excess return is what the manager earned in excess of a passive index, after adjustments.
For example, in the five years ended June 30, the American Funds Washington Mutual Investors fund has a relatively high omega return (17.9%) but a negative excess return, -0.7%.
That means that although the fund did well, you could have done even better by replicating the fund's style with passive indexes. The fact that the fund took 10% less risk than its style benchmark (style beta = 0.9) is taken into consideration in the excess return. The R-squared of 0.92 indicates passive indexes account for all but 8% of the fund's returns.
Of course, style analysis is not a perfect science. It would be advisable to employ a consultant to make that determination.
The AIM Value fund, on the other hand, ranked about the same on the basis of its five-year omega return but did 100 basis points better than a passive strategy that replicated the fund's style.
Who will prove to be the fairest fund of all in the future? That depends to a great degree on which style is the fairest in the future. AIM Value has equal weights in large- and small-capitalization stocks. American Funds Washington Mutual is 91% large cap. If one could forecast the size and style that would perform best, then managers who earned to omega excess return for that style profile should have a good chance of winning the beauty contest.
All of these statistics were developed using the performance model and data base of LCG Associates, Atlanta. The procedures for making these calculations are explained in detail in articles found on www.sortino.com.
Frank Sortino is director of the Pension Research Institute, Menlo Park, Calif.