You’re looking at last year’s holdings in your investment portfolio and wondering if the returns you earned justified the fees you paid. While many investors rely on third party rating services such as Morningstar’s five-star rating, there’s more to evaluating a portfolio than counting the stars!
Many investment managers claim to actively manage as a means of differentiation. However, not every portfolio is truly very different from the passive index.
So how do you decide what investments to keep and what to sell?
Employ the ABC’S of manager selection!
The ABC’S, or the “Alpha, Beta, Capture, and Sharpe” process, is a disciplined screening process that may help you more effectively evaluate how well your portfolio managers are really handling your investments. Here’s how to break the process down.
Alpha refers to the value added by a manager. This measures how different the manager’s holdings are from the index. The lower the ratio, the more similar a manager is to a benchmark, and a score below 80 (the maximum is 100) should raise a flag.
Beta measures the level of a manager’s risk that is attributable to market movements, usually comparing the manager to the S&P 500. For example, the S&P 500 has a beta of 1.0, hence, a higher beta is more volatile than the broad market index. It is usually preferable to see managers achieve returns with below-average volatility.
Capture Ratio measures how a manager performs in both up and down markets. An up capture ratio greater than 100 means the manager gained more than a broad market benchmark when the benchmark is positive. A downside ratio less than 100 means the manager lost less when the benchmark is negative. An alarming number of portfolios have an upside and downside capture ratio close to 100, meaning they are disguised as an actively managed portfolio, but you may really be paying high fees for an index approach.
Sharpe Ratio is the final number to look at in your evaluations. This ratio compares returns in the context of risk. In other words, it may not be a good idea to build a portfolio based solely on investments with the highest return at the time. A higher Sharpe ratio indicates more return for the same risk. Hence, the higher the Sharpe ratio, the more attractive the portfolio.
Once you’ve determined the manager you’ve selected have met the ABC’S test, it’s important to remember that it’s a good idea to diversify your portfolio so that the holdings complement each other.
Investing is complex and it isn’t always initially clear which portfolio will suit your needs, but understanding the ABC’S may help you build a solid foundation for your investment portfolio construction.
Deborah Stavis is a member of the DailyWorth Connect program. Read more about the program here.
Securities offered through FSC Securities Corporation, member FINRA/SIPC. Advisory and insurance services offered through Stavis & Cohen Financial, a registered investment advisor not affiliated with FSC Securities Corporation.
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Investing involves risk including the potential loss of principal. No investment strategy, including diversification, asset allocation and rebalancing, can guarantee a profit or protect against loss. Indexes are unmanaged and cannot be invested in directly.