Analyze Charts Graphs

An Analysis of the Returns of XYZ Capital Management

Analyze Charts Graphs

I recently received a performance report from a firm I will name XYZ Capital Management (XYZ) to hide it's identity. XYZ claimed to have beaten the S&P 500 by about 10% per year for over 12 years. When I am presented with these claims, the first measurement I like to look at is whether the correct benchmark was used to measure the performance of the portfolio. I have often stated that the missing link in investment performance analysis is proper benchmarking. Active managers have been known to have tilted their stock picks to small and value firms and then compare their performance to less risky large blend stocks like you find in the S&P 500. A classic example was Bill Miller at his Legg Mason Value Trust comparing his returns to the S&P 500 instead of a Large Value Index, even when Value is in the name of the fund. As you can see from the chart below, there is a 50 year historic record that shows that US Large Value and US Small Value stock indexes have outperformed the S&P 500 Index. In addition, there has been empirical peer-reviewed research published by Eugene Fama and Kenneth French.

So it would be expected that if an active manager owned mostly small and value stocks they would have taken greater risks and therefore earned higher returns than the less risky stocks for the S&P 500. The better question to ask is, "did that manager outperform an index of small and value stocks?" I would argue that the XYZ manager using the S&P 500 as a benchmark would be using an incorrect measurement, given that XYZ describes itself as a “value-oriented” manager, and several examples of companies that XYZ has invested in could be categorized as small-to-mid-cap value.

I was also provided with returns for over 12 years, including the returns from another prior fund (ABC fund) that existed for 2 years and 2 months before this fund. I also would argue that returns data from the ABC fund, which was prior to Jan. 2003, should not be used since those returns were for a different fund. The XYZ fund currently has about $80 Million, so I suspect that the amounts from Nov. 2000 to Dec. 2002 were relatively small, but I do not have that data. I also suspect that the high returns reported from November 2000 to December 2002 were likely caused by a few stocks that had very high return. This is a common pattern that we see in hedge fund returns--that the highest returns occurred at the fund's inception when it had the least amount of assets to invest, and thus had a high amount of concentration risk. Here is the data and notes I was provided:


Another important factor is to check if the returns are net of management fees. These returns were before fees, otherwise known as Gross of Fees.

The benchmark that IFA chose for XYZ is an investable passively managed small cap value fund from Dimensional Funds Advisors (DFA), the Small Cap Value Portfolio (DFSVX).  This mutual fund has been available to institutional and advised individual investors since 1993. The managers of this fund make no attempt to identify “undervalued” companies via fundamental analysis nor do they seek out “special situations” or “activist/control” opportunities, several of the excuses used by active managers to find unfairly priced equities. DFA simply buys companies that meet the quantitative criteria for small value and holds them until they no longer meet the criteria, an investment strategy that has been backtested all the way back to 1928. It is our opinion that the risk of this fund is comparable to, or even less than, the risk of XYZ. In fact, XYZ looks even closer to the risk of an index of International Small Value stocks, which had an even higher return than the US Small Value stocks in this period.

In the chart below the XYZ fund was plotted with 20 IFA Index Portfolios and the component IFA Indexes to put it into perspective. As you can see a globally diversified portfolio of 70% stocks and 30% bonds earned aboout the same return as XYZ, with about half the risk. Note that the standard deviation of XYZ is much higher than the S&P 500 Index, calling into further question the decision to use it as a benchmark. Standard deviation has been a recognized measure of risk for equities since 1952

When we compare the ten years (2003 to 2012) of XYZ returns to DFSVX, we find a negative average alpha of 2.6% over the 10 year period. The chart below shows the alpha in each year. In five of the ten years, it was negative. So when compared to a more appropriate index, XYZ did not beat that market.

On September 3, 2013, I sent an eamil to the manager of XYZ asking the following questions: 1. I see you offer audited financials upon request. I would like to see them. 2. Do you have monthly data for this period. 3. Can you provide net of fees returns.  I received a phone call, but no answers to these questions as of the date of this posting.