Join the presenter, Ted Ponko and other participants following Wednesday's Live Virtual Seminar (10/17, 3:00 PM ET) as they share thoughts about the presentation.

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Has Mr. Ponko seen any "classic" combinations of 4 factors, one from each category, that have been used with some frequency?  What are his comments on a 4-factor model consisting of absolute return, beta, sharpe ratio and batting average? Assume equal weighting to those factors...Thank you.

Hi Bruce--

Your four factor model (absolute return, beta, sharpe ratio, and batting average) isn't bad.  R-squared could help as far as beta and batting average, but that also brings up another issue:  Since both beta and batting average must be measured against an index, it's important to get the statistics versus the same index.  Morningstar's primary index would work but more appropriate might be a style index like one of the Russells or S&Ps.

As far as our research, we've found a good four-factor model can be constructed based on Expense ratio (highest importance), Absolue Return (second highest), Alpha (third highest), and Worst Year (3-year period).  There's information about this at our website (www.kleindecisions.com).  Look for Klein Fund Ratings.

In response to Steve's question:

Steve asks: Once you have created your preferred list of funds, what criteria do you use to eliminate a fund from the list?

A lot of this is up to you and how you'll be using the funds.  Popular back-end screens include Expense Ratio, Manager Tenure, R-squared, Load or No Load.  Other factors to consider would be number of holidngs (eliminate or select concentrated funds), other expenses, or even distinct portfolio.  Be careful with that last one, espeically if you're using it along with other factors.  You may end up completely eliminating all share classes of good funds.

In response to Don's question:

Don writes: I struggle b/w being being a passive and active investment advisor. It seems that even after I go through this process, the performance results could still be due to manager luck. How can I eliminate the possibility of ending up with funds that come out on top due to the manager successfully rolling dice?

This is a good question.  I think a lot of advisors struggle with this one.  If you're worried about managers taking undue risks to create returns there are several things to consider.  First, Informtion Ratio will show you the manager's risk adjusted return.  You can set limits on it to assure that any excess return is coming from skill, not risk.  Secondly, you might want to emphasize measures of consistency.  Rolling batting average would be a good way to get a feel for how the fund has performed over various periods.  

As far as the active/passive decision, the main thing to keep in mind is this:  We haven't experienced a bear market in over five years.  When we do again (and we eventually will) index products will fall with their benchmarks.  Active managers have the ability to switch out of losing positions or even hold cash to cushion the blow.  Index products don't have that luxury.  If a pullback is short and rather mild -- as recent ones have been -- you won't notice much of a differnece.  But if there's a prolonged bear market as there was from 2000-2002, a lot of investors will be rethinking the value of index investing. 

In reply to Billy Bob's question:

Billy Bob asks: Do you consider it worthwile to consider portfolion wieghting using beta?

I guess a lot depends on what you're seeking.  If you are using beta as a measure of overall portfolio risk and adjust asset mix based on the client's risk/return preference, it can make sense.  However, beta only measures market risk, not the overall fund or portfolio risk.  Two other factors -- non-market risk and correlation -- come into play.  You can have a portfolio with low beta funds, but still have a great deal of risk if the manager is straying from the market (low R-squared) or if the funds are highly correlated.  I think a better approach is to consider the overall portfolio risk taking into consideration beta, non-market risk, and correlation.  One of the beauties of MPT is that it shows how individually risky assets can be combined to create a portfolio with better return and possibly even less risk. 

In response to Josh Pitlosh's question:

John Pitlosh wonders: How do you handle, evaluate, or address overlap in your portfolios?

Overlap really isn't an issue in fund evaluation, it's an issue for portfolio construction once you've selected the funds you want to use.

When constructing portfolios, I've never really worried too much about overlap because I've always focused on the portfolio's overall risk and return.  Theoretically, overlap will take care of itself because fund that share a large number of holdings will be highly correlated, increasing portfolio risk at the expense of added return.  I've always focused on the overall portfolio risk rather than that of its individual components, so haven't been to concerned about overlap among issues.

In response to William Mack's question:

William Mack asks: What is the cost of the K4 fund [Selection]?

The annual subscription is $1495, however as a special offer to FPA seminar participants, we're offering it at $1120.  You can see the offer and try out the product at

http://www.kleindecisions.com/products_fund_selection.htm

In response to Steve's question:

steve asks: What is your answer to those who say that data show that managed funds can't outperform indexes over time, so all the effort to select funds is wasted?

I really don't have a response to that.  On the one hand, I think evidence is pretty clear that the average mutual fund manager really can't outperform over the long-term.  A few have been able to, but the fact that you probably know their names -- there's so few of them -- attests to the problem.  What we don't know is if active management can outperform over the short-term.  I suspect it can if for no other reasons than the fact that various sectors of the market will always underperform or decline.  Index funds tracking those benchmarks will, too. 

Given this, I think portfolio managers should try to steer their clients' holdings into actively managed parts of the market or inefficient parts (e.g. emerging markets) when the indexes are headed down and then back into indexes for those areas that are outperforming.  I'm currently doing some research on this precise approach, but it's only about a year out of sample, so it's too early to draw any conclusions.

In response to Heidi's question:

Heidi Davis writes: How do you factor in past stewardship issues of the fund family (after hours trading, special terms for large traders)?

Stewardship is one of those factors that I would have to classify as qualitative rather than quantitative.  To be honest with you, I don't know if, over the long-term, stewardship really makes a difference in regard to return and/or risk, yet it is a factor many of us feel is important to consider.  As a qualitative factor, it's not something you can put a absolute value on, but more of an approach or attitude about a manager and portfolio.  I truly believe this is something you and your clients need to define and agree upon.  In fact, it may be different from client to cleint.  I know this probably isn't the definitive answer you were hoping for, but I don't believe this is something others can decide for you and your clients.

In response to Johanna's question:

Johanna asks: How often do you recommend running the screening process to rebalance?

You may be asking one of two things here, so here are two different answers:  I think fund evaulation should be done monthly, if for no other reason than to see how your funds are faring relative to one another.  If in the middle of the quarter you see a fund that had previously scored well is suddenly falling, you may not want to rush to sell, but do have the knoweldge that it's something you might want to watch over the next few months.  If you're using your screening process to develop a buy/sell list, once a quarter is probably often enough to generate the list, but you should review fund relative performance on a monthly basis.

Now, if you're asking about how often you should rebalance a portfolio, I would suggest reviewing portfolios once a quarter.  That doesn't necessarily mean rebalancing them that often but review them that often.  Only rebalance at the end of quarter when at least on postition has strayed more than 5% from your target for that category.  Smaller moves may be offset in the coming quarter, so not rebalancing when there are relatively small moves can save your client both taxes and transaction costs.

In response to Risk's question:

Rick writes: Where can I find batting average for a fund?

It's actually harder than it should be.  This isn't something that's in Morningstar or most data providers.  You can calculate it yourself if you have month-end fund and index data for the funds you want to evaluate, but the easiest way to use it in fund evaluation is (hate to sound too commercial) K4 Fund Selection

(http://www.kleindecisions.com/products_fund_selection.htm)

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