In the Feb. 7 issue of Pensions & Investments, I used an old Henny Youngman joke to illustrate the need for a performance measure that keeps people from hurting themselves by getting into high-risk funds at the top of a market cycle. I proposed the upside-potential ratio, which is the average return in excess of the minimal acceptable return, divided by the downside risk of the manager's style. An MAR of 8.6% was used in this analysis because it is the return the average investor is assumed to require in order to accomplish her goal.
Based on returns for the five years ended Dec. 31, three funds were selected in that issue that had the highest U-P ratio and a positive omega excess return: Fidelity Dividend Growth; Capital Research Washington Mutual; and Capital Research American Mutual. All three are once again in the top quartile, but American Mutual now has a negative omega excess return.
In that issue, the three funds with the highest 1999 returns were: Putnam OTC Emerging Growth; Fidelity Aggressive Growth; and T. Rowe Price Science and Technology. Interestingly, none of these three showed up in the U-P ratio ranking because P&I prints only the top 50 funds, and they fell below 65.
Since that issue of P&I, we have had a severe market correction. According to figures provided by Bernardo Kuan at DAL Investment in San Francisco, the Nasdaq composite peaked at 5,048 on March 3; by May 31, it had plunged 33% to 3,400. This provided a good test for the efficacy of the U-P ratio as a performance measure that provides protection on the downside while taking into consideration the upside potential.
As the "Downside protection" chart illustrates, using the U-P ratio, Fidelity Dividend Growth, Cap Research Washington Mutual and Cap Research American Mutual had positive returns over the past year with an average gain of 13.5%. Putnam OTC Emerging Growth, Fidelity Aggressive Growth, and T. Rowe Price Science and Technology, which had the highest annual returns, unadjusted for risk, all suffered declines. The average decline was a devastating 37.5%.
The Putnam, Fidelity Aggressive Growth and T. Rowe Price funds were ranked based on what did happen over the year ended June 30. Fidelity Dividend and the Washington Mutual and American Mutual Cap Research funds were ranked based on what could have happened, given the manager's style and 2,000 years of possible annual returns from the bootstrap procedure (for details, see "Managing Uncertainty" at www.sortino.com). Yes, they are different methodologies. Yes, the highest-return methodology is easy to calculate, but results in people getting hurt in sharp selloffs. Yes, you do need a graduate degree in mathematics plus computer programming skills to build a model that will calculate the U-P ratio the way we do at the Pension Research Institute.
However, you don't have to know how to build an airplane in order to fly one, and you don't have to know how to fly one to use it to visit far-off places. There are only a few airplane manufacturers, but many airlines and thousands of trained pilots. Similarly, you don't have to know how to build complex models to get useful statistical insights. There are a few consulting firms capable of building decision models like Bill Sharpe's and mine, and thousands of advisers capable of learning how to fly these models.
For those who know how to use the Internet, cutting edge technology is available for less than $50, so cost is not a barrier. FinancialEngines.com charges $49.95, and Quicken.com offers a free service through TeamVest that soon will incorporate the U-P ratio. Just as Morningstar forced other ranking services to consider risk, the Internet is going to force advisory services to use the latest technology for measuring performance and recommending asset allocations.
The days of charging investors for financial services based on 50-year-old technology, or no technology at all, are coming to an end. People will not fly on noisy prop-driven planes if they can fly in a jet that is faster and safer.
I hope this recent experience will prompt consultants to start calculating U-P ratios as an additional bit of useful information. The formula can be found at www.sortino.com.
The top-performing fund for the second quarter was Dodge & Cox Stock fund. The upside potential is 1.33, which means it has 33% more upside potential than downside risk. The omega excess return of 3.9% indicates the fund could produce 3.9% more, on a risk-adjusted basis, than a set of passive indexes that replicate the manager's style.
A word of caution: The rankings shown assume an investor wants the highest upside potential to downside risk ratio, regardless of style. I think investors should be diversified across styles.
The current rankings were produced with mutual fund returns and an expanded set of indexes provided by LCG Associates, Atlanta. SAM, a proprietary model developed at PRI, generated the statistics.
Frank Sortino is director of the Pension Research Institute, Menlo Park, Calif.