Typically, an asset manager (depending on the size of a fund, which can range from several million to over a billion dollars) would invest in tens or even hundreds of different companies, while retaining small percentage of capital in cash (usually, short-term money market, CDs, Treasuries, etc.) There is a clear benefit of diversification, however, once investment is made in a number of companies (exceeding, 30 to 50), the investment performance tends to diverge to a market average.
Therefore, any above average market performance, to a large degree, depends upon manager’s skill. Moreover, return alone is not the only indicator of performance. What’s also important is the risk-adjusted return, or alpha. A positive alpha means that a manger has earned a positive return adjusted for risk. The higher the risk, the higher the required expected return.
Thus, the saying there’s no free lunch on Wall Street. A negative alpha means the manager’s return has failed to create a positive risk-adjusted return. For example, if the required return, based on risk measures, such a standard deviation (a measure of dispersion around the mean, hence volatility) for Fund A is 10%, and the manager has gained 9%, the alpha is minus 1. On the other side, if for Fund B, the required return is 7% and the manger returned 8%, a positive alpha (plus 1) has been generated, meaning that Fund B has performed better on a risk-adjusted basis, even though in absolute terms it had a lower return than Fund A.
It is important to realize that since different asset classes have various volatilities, different returns to compensate for risk are expected. In general (although, there are exceptions), equities have higher expected returns than bonds. There are other measures of performance such a Sharpe Ratio, which shows whether there was a sufficient compensation received for the risks taken. The higher the Sharpe Ratio, the better the fund has performed, adjusted for the risk. Thus, a manager with a Sharpe Ratio of 1.5 has performed better than a manager with a Sharpe Ratio of 1.2. (However, it needs to be remembered that this ratio is only one measure of performance among many). For example, Information Ratio will also show how well the manger has performed relative to a benchmark (such as S&P 500) on a risk-adjusted basis (an Information Ratio of 0.5 and higher is considered to be good).
Alpha, Sharpe Ratio, Information Ratio, and other indicators can usually be found in mutual fund prospectuses and fact sheets. What’s crucial to understand here is that an asset (and it includes a mutual fund) will exhibit volatility (whether upside or downside volatility). As a result, a fund with high volatility (and thus risk) needs to earn more to compensate for these fluctuations.
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