Manager Value-Added (MVA): a powerful tool to measure your fund manager's results and beat the market
MVA is a powerful concept that defines the extent of value added by active portfolio management. It's about how much value you are getting in return for the fees you pay to your fund manager. Managers with high MVA add value and can beat the Index.
There are several ways to measure value-added from active portfolio management. The most simple, and superficial way to do it, is to compare your fund's return to that of its benchmark Index. This is what inexperienced investors do. If their fund's return exceeds that of the Index, they interpret it as an indication that their fund manager is adding value. If it does not, they think they should dump the fund. Why pay the high fees if you can get better returns with an Index fund?
For the less sohisticated investor, there is nothing wrong with this line of thinking which, as a matter of fact, is adopted by traditional mutual fund software and web sites. Performance tables compare fund results to Index returns, leading investors to conclude, in the majority of cases, that fund managers cannot beat the Index.
The problem with that method is that it does not compare apples to apples. It's like saying: my apple tastes better than your orange. Fine, if that makes you happy, but I still like oranges more than apples.
At FundScope, we help you compare apples to apples. We want you to properly measure and evaluate your fund manager's returns, so that you can make informed decisions. Informed investors can make better decisions or can use their knowledge to lead more intelligent and more fruitful discussions with their advisors.
To compare apples to apples, not only you should compare your fund's return to that of the Index, but also the risk level associated with each of the two alternatives. Comparing only returns and ignoring risk is like looking at one side of the coin. It's misleading, irrelevant and flies in the face of the most basic investment principle, namely that higher risk should result in higher return.
Astute or experienced investors require higher return when they assume more risk. This is Investing 101. For example, equity investors expect higher return than bond investors. At the high end of the risk spectrum, venture capitalists who finance a new venture require a stake of it or charge 30% interest. It's simple: they want to be compensated for the risk of loss with very high returns.
For risk takers, higher return is therefore important. Investors who assume a higher risk, but do not get a higher return in exchange, are being short-changed. If fund manager Baker assumes more risk than fund manager Smith, Baker should be able to generate higher returns than Smith. Otherwise, Smith will be referred to as an "inefficient" fund manager. He or she did not know how to take full advantage of the additional risk assumed in order to generate higher return. The efficient manager is he or she who can generate incremental return in exchange for incremental risk.
Time for a real life example: for the year ended two thousand something, Fund A, an actively managed Canadian equity fund, earned 15.5%. For the same period, the Index earned 15.6%. For the inexperienced investors, Fund A is perceived as a mediocre fund, inasmuch as its portfolio manager did not add any value compared to the Index. Why pay him or her any fees?
The picture will look completely different, however, when you take into account the risk assumed by each fund. For the same period, Fund A reported only 74% of the Index volatility. In other words, it is 26% less risky than the Index. Was the Index return sufficiently high to compensate its investors for more risk?
COMPARING APPLES TO APPLES|
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| Risk |
| Fund A | 74% |
| Peer Group Risk | 83% |
| Index | 100% |
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| Return |
| Fund A | 15.5% |
| Peer Group Return | 8.9% |
| Index Risk-Adjusted Return | 12.0% |
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| Manager Value-Added |
| Fund A return | 19.90% |
| Index return | 15.60% |
| Risk-Adjustment Factor (RAF) | -34% |
| Manager Value-Added | 4.3% |
Using the above table, entitled COMPARING APPLES TO APPLES, we can tell you at a glance which fund is more efficient. We do it in two ways and reach the same conclusion. The first way consists of recalculating the return of Fund A assuming a risk level equal to 100% of the Index risk. Here, we say: if the manager of Fund A assumed a risk level equal to 100% of the Index risk, how much return could he or she have delivered? The answer would be 19.9%. In other words, if this fund manager increased his or her portfolio risk from 74% all the way up to 100% of the Index risk, he/she could exceed the Index return by 4.3% (that being the difference between 19.9% and 15.6%). We refer to that excess return of 4.3% as Manager Value-Added or MVA. Note that, to go from 74% to 100%, you are increasing risk by 34% (using 74% as a base). This 34% is referred to as the Risk-Adjustment Factor.
You can also apply the same concept using the other side of the coin. In other words, you can recalculate the Index' return by reducing its risk to 74%. The recalculated return of 12% is referred to in the table as the Index Risk-Adjusted Return. Conclusion: if the Index had a risk level similar to that of the actively managed fund, its return would be significantly inferior. In other words, the Index fund is less efficient than Fund A.
This notion of calculating a risk-adjusted return for the Index is an excellent benchmarking tool. It allows investors to compare apples to apples, by comparing the returns of both funds assuming equal risk levels. The Index' risk-adjusted return is a more relevant benchmark than its official return. It tells investors: if you selected the stocks of the benchmark Index and combined those stocks in a lower risk portfolio, those stocks would have delivered a lower return.
The assumption here is that investors should select an investment that carries a risk level that they can afford. Suppose that, upon evaluating your risk tolerance, you concluded that the maximum risk level that you could afford is 75% of the volatility of an Index fund. To reach that risk level, you had two alternatives:
Alternative 1: buy Fund A. That alternative would have delivered a 15.6% return.
Alternative 2: buy the Index and combine it with cash balance to ensure your maximum investment risk does not exceed 74%. That alternative would have delivered a 12% return. Which one was a better choice?
Clearly, for the risk level that you chose, Alternative 1 is far superior. For you, the fact that the Index delivered 15.6% is irrelevant because you are not comfortable with the level of risk associated with it. What you need is a fund that maximizes your return without exceeding your tolerance for risk.
What if you thought that an investment risk of 100% was acceptable? First, let's go through the alternatives:
Alternative 1: buy the Index. That alternative would have delivered 15.6%.
Alternative 2: put all your money in Fund A. As such investment would carry a 74% risk, you could increase your risk by borrowing enough money (based on a 34% RAF you would need to borrow an additional $34 for each $100 invested). This alternative would have returned 19.9%.
Of course, we are not asking you to borrow money to increase your portfolio risk. But we are mindful that every normal portfolio would contain an equity fund, a bond fund and a money market fund. Therefore, just as you apply the MVA concept on individual fund selections, you can use it to alter your equity/bond/money market portfolio mix to reach the desired risk level. You will find that, if your portfolio is made of efficient funds with positive MVA, your investment portfolio will out-perform a similar portfolio made of Index funds for any risk level that you chose. If you have not already done so, it's time for you to read about The FundScope Way .