To do this, we're going to need the following tools:
The right benchmark for each of our asset classes
Reliable data sources
An understanding of the following metrics:
Manager experience and tenure
Consistency of excess returns
A way to manage a potentially limited selection (i.e. inside of a 401(k) plan)
Let's start with selecting the appropriate benchmark for the hypothetical four-asset portfolio we developed in my last article. If you are going to evaluate skill, you have to have a consistent, reliable comparison. This isn't always as easy as it sounds, as two funds with similar sounding names can use very different comparison benchmarks and possibly even have two very different objectives. In our case, we will use the following asset classes and recommended benchmarks:
U.S. Stocks – Standard & Poor's 500-stock index
International – MSCI EAFE (Morgan Stanley Capital International Europe Australasia and Far East) index
U.S. Small Cap – Russell 2000
Bonds – Barclays U.S. Aggregate Bond index
(You may note that I am using the Russell 2000 index for small cap U.S. stocks. This is because the tools we will be using may not have access to the Dimensional U.S. Small Cap index that I used in my last article.)
Now we need some good data sources. The tools I use are Morningstar, Fiduciary Analytics (from the Center for Fiduciary Studies), Evestment, TD Ameritrade's fund and ETF research and information from the mutual fund's own sites.
When evaluating skill, and the potential for persistently better results than the index, there are a few statistics that can help us. The first is alpha, which measures the active return on an investment, or the return that is in excess of the comparison benchmark. We may be interested in average alpha, over a period of time, such as three years, five years or 10 years, but I recommend looking also at this metric on an annual basis, to get a sense of consistency. Averages, whether they are performance averages or other statistical measures, tend to get corrupted easily by big differences in select periods, so look at each year.