Mutual Funds: Know Where the Risks Lie

As the alleged Ponzi scheme run by money manager Bernard Madoff has made clear in recent days, people put their money into "black box" investment strategies at tremendous risk. The scandal underscores the need for investors to have access to more information about how their returns are generated.

Performance measurement and attribution systems, as the most sophisticated of these tools are called, account for a growing niche within the business technology sector. Thomson Reuters (TRI), StatPro (SOG.L), and SS&C Technologies are the top three providers of installed standalone software systems used by pension fund sponsors, endowments, and other institutional investors, and a growing number of smaller boutique firms now offer similar tools, according to a September 2008 report by the Aite Group, an independent research firm in Boston. Retail investors have little need for the specialized information these software platforms provide, but some of the data could help them decide which mutual funds to invest in.

Some market professionals believe the bear market has increased investors' desire to identify where a fund's returns come from now that gains are harder to come by. David Spaulding, president of the Spaulding Group, a money-management consulting firm in Somerset, N.J., and a leading provider of training in performance measurement, says these tools have become more important over the past decade as part of the natural desire for as much information as possible. And while the concept of attribution—which distinguishes returns due to asset allocation from returns due to stock selection, currency effects, and other factors—goes back nearly 40 years, the technology that supports it has been available for only 10 to 15 years, he says.

Predicting Returns

Spaulding says attribution becomes more important when managers try to explain losses to their clients. "We know of cases where managers will sit down with clients and say, 'We had a bad year, but I know why it happened, and this is what we're doing to correct that,'" he says. "That ability clearly has value. It gives the client some confidence in the manager that he has his finger on the pulse [of the market] and is taking corrective action."

Philip Silitschanu, senior analyst at the Aite Group, notes a trend over the past two to three years to use newer performance measurement and attribution systems not just as a reporting tool but also as a way to predict future returns. Martin Gruber, a pioneer of mutual fund research and a finance professor at New York University's Stern School of Business, believes investors can study how certain fund styles have performed over time. But he believes that it's easier to predict a fund's negative returns than positive returns based on past performance. "Bad managers tend to stay bad managers," he says. "Good managers tend to a lesser extent to stay good managers."

One of the most basic things an investor needs to understand when it comes to investing in mutual funds is a 30% positive return in any year may not actually be the investor's return, because it depends on when he put money into the fund. The timing of investors' contributions and redemptions affects their returns. For example, if a fund's net asset value goes from $10 to $20 per share, and at that point money pours in from new investors, and the NAV then settles back to $13, those people who invested money when the NAV was $20 may have lost some money. But the portfolio manager will still report a 30% return because the fund's value rose from $10 to $13, says Spaulding.

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