Who can make money in a market like this? Well, if you were in large-cap growth last quarter, it was a question of who lost less. The upside-potential ratio, however, identified funds that actually made money in the large- and small-cap value categories. Furthermore, the ratio was able to identify the good and bad performers for the coming quarter. But is that what performance measurement is all about? Unfortunately, the answer is yes. It's wrong; it's dumb; and yet, it's what every performance measurement survey does.
First came the Sharpe ratio, then the Sortino ratio, then the Information ratio. All of these suffer from the same fatal flaws:
* They look at only the manager's returns, not the returns of the manager's style;
* They look at only what did happen, not what could have happened;
* They look at only short periods, usually one year or less; and
* They have no predictive power.
A few solutions
There are some ways to address the problems:
* Identify the manager's style with the returns-based style analysis procedure developed by Bill Sharpe at Stanford University;
* Identify what could have happened using that manager's style for the past 20 years using the bootstrap procedure developed by Bradley Efron, also at Stanford University; and
* Measure the upside potential and downside risk associated with that manager's style.
If you don't know how to make the calculations referred to above, the Pension Research Institute will make available free software that will make these calculations from any set of monthly data, as well as the source code. Details are available at www.sortino.com.
But these steps don't solve the problem of focusing on short-term results. The solution? Stop asking for them. Stop looking at them. The industry is structured to give you what you want. So demand something designed to put you in the upper quartile over the long run. A study in progress by Bernardo Kuan at DAL Investment in San Francisco indicates a strategy employing the U-P ratio could have achieved that goal over the past 20 years.
Looking at the large growth sector of Pensions & Investments' universe of mutual funds with the most defined contribution assets for 2001, Wells Fargo Diversified Equity has the highest upside-potential ratio. Its U-P ratio of 1.09 means the fund has 9% more upside potential than downside risk. Not much different from Capital Research & Management Co.'s AMCAP fund, which has five times the Omega excess. In other words, AMCAP could earn 10% more on a risk-adjusted basis than a passive set of indexes that replicate the style used by AMCAP.
In the large value sector, Fidelity Value has 28% more upside potential than downside risk, but it could earn 2.2% less than a passive style benchmark. So Dodge & Cox once again heads the list of large value funds.
Frank Sortino is director of the Pension Research Institute, Menlo Park, Calif. Fund data were provided by LCG Associates in Atlanta.