Monday, October 19, 2009

In Your 401(k): Looking at Worst case Scenario Instead

It is simply our nature. Even when we think we are acting in our own best interest, we often allow optimism to rule most of our investment decisions. Yet, if we look closely at the worst case scenario instead of the best possible outcome, we might uncover some interesting tidbits of information that could help us achieve better results in our 401(k)s.

By now, most of us now realize that our mutual fund investments, particularly those in our retirement accounts, can go down, often dramatically. Until recently, we paid little attention to how bad a fund can perform, focusing instead on how well it can do.

Some of us use those online retirement calculators to help. Others simply look at historic gains and predict where we will be balance-wise in the far off future. We make random estimates of how much money will be in the account when we choose to begin drawing it down. And as we now know, this can be less than we anticipated (just ask anyone who has postponed their retirement because of a lower than expected balances).

So how do you determine the performance of a fund, or better, the risk that the fund will do what you intended it to do?

The Blame Game, revisited
Some hedge fund managers think they have the answer. It is complicated? Yes. Is it impossible for the average investor to determine? Not if you consider the manager as the sole blame for the fund's performance.

Mutual fund managers are part of the equation you use to pick a fund. Tucked in amongst the performance of the fund, the underlying holdings and the fees, we look at the fund manager's tenure. The assumption being that the fund manager will do much better the longer s/he has been at the helm. Tenure also assumes that the fund will have stabilized over the period that the manager is in control.

Fund managers as we (should) know must follow the charter of the fund. This is not as easy as it sounds. Far too many fund managers fail in their attempts to avoid style drift, a notoriously common occurrence whereby the fund manager tries to imitate whatever index works, in the hope of mimicking the return of the benchmark it will compare itself to at the quarter's end. This is managing for the upside, often shifting holdings at or near the quarter's end to give the appearance of better-than-average performance.

So we look at the end result when we should be looking much more closely at what occurred during the periods between reporting.

Some fund watchers suggest that simply looking at these sorts of results is not only the wrong thing to use as a way to decide where to invest but will also cause you to assume that good times are part of the continuing experience of investing. As we know, markets go down. How the fund manager did during this peak to valley performance is, as some are beginning to realize, a better indication of how well the fund has done and the manager has performed.

Richard Gates, portfolio manager for TFS Capital thinks "the best way to estimate risk is to try to quantify a portfolio's downside volatility. In other words, how much money can I lose in a given period of time?"

Wandering in the Valley
Volatility is an excellent measure of the fund's performance during certain periods. But few of us look at the way the fund manager managed the portfolio (during her/his current tenure and better, their performance in the past) as the indication that your fund will do as expected in the future.

Fund managers are awash in information and you rely on their ability to parse this information, apply it to where you would like the fund to go in the future, and limit the downside risk. Your fund may have lost money; but did it lose as much as comparable funds (benchmarks excluded)?

Some analysts suggest that instead of looking at the best day and make withdrawal assumptions based on that point of reference, you should look at the worst day, the moment when your portfolio looks its weakest. If is better than most, you have hooked your fortune to the right manager.

But don't limit your assumptions with the current fund under management. Look at all of the performance results from every fund they have managed. Digging a fund out of a bad period is perhaps the best indication of the fund manager's expertise.

This is no easy task. Funds on the downside of expectations face some unusual pressures. Investors bail in disgust forcing redemptions to rise which force the fund manager to sell underlying winners. This creates a tax situation that all of us would have rather be avoided. There is less money to channel towards new investment opportunities and the fund struggles. How they turn this around may be the single best indicator of their skills. Past results, it seems, matter more than you might expect.

Paul Petillo
Managing Editor/BlueCollarDollar.com
Contact Paul with questions.

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