Before deciding on any public equity investment in an actively managed fund, you should consider the SAMURAI test. What is it exactly? The SAMURAI test is an acronym that stands for the following.
- (S)pecified In Advance
- (A)ppropriate for the Manager’s Style and Constraints
- (R)eflective of the Manager’s Views
- (I)nvestable at a Low Cost
Here's a following example of how to use the SAMURAI test with analysis by Morningstar of an absolute return fund that tries to return a positive result in a bull market and a bear market.
The SAMURAI Investing Test Before Making An Investment
(S)pecified In Advance–Pass
The first requirement of a valid benchmark is that it is specified in advance. We’ll give target-return funds credit for this one, even though some managers make investors work harder than others to find out what the actual target return is.
Putnam Investments wins the award for the most transparent target-return funds in this sense, as the four target-return funds it offers have target-return above cash in the fund names.
Putnam Absolute Return 500 (PJMYX), for example, targets returns of cash plus 5% over rolling three-year periods.
(A)ppropriate for the Manager’s Style and Constraints–Fail
Most reasonable investors would agree that it doesn’t make sense to judge a large-cap value fund’s performance versus a large-cap growth index. Absolute returns don’t have a style because they are literally just a number. But target-return managers can, which means they can fall short of their goal or overshoot it based on whether that style of investing is in favor.
When measuring a manager, it is important to separate beta–that is, market or factor returns that an investor can purchase cheaply in an index fund–from alpha, which is a sign of manager skill and much more scarce.
Of the target-return fund managers, some fall firmly in the value investor camp, like GMO Benchmark-Free Allocation and JHancock Global Absolute Return Strategies (JHAIX). While others like AQR Style Premia Alternative use a mix of factors including value, momentum, and low beta. Despite the different styles, each fund targets returns of at least cash plus 5%.
Because styles can go out of favor for extended periods of time, these tilts can have an adverse effect on performance over short- or medium-term periods. GMO’s value bias, for example, has led to a defensive portfolio that has lagged peers over the trailing five years as stocks and bonds have rallied.
Over the five years ended March 31, that fund returned 3.9% versus 1.2% for the US Bureau of Labor Statistics CPI All Urban Not Seasonally Adjusted Index, giving the fund an absolute return of about half its bogy.
Provided the fund states its target return in advance, it is very easy for an investor to measure if it has hit that goal over various time periods.
Target-returns are completely ambiguous. Pick a time period and you are likely to come up with a plethora of various allocations that would reach a target return above cash regardless of the level. Because this is only easily done in hindsight, it is hard to know what mix of assets a manager targeting a given return should invest in.
For example, the managers at AllianzGI Structured Return (AZIAX), an options-based strategy, target the same return over cash, 5%, as the multiasset portfolios run by GMO, JHancock, and a slew of other more global macro-oriented managers. Both funds are using different tool kits to seek to arrive at the same end point.
(R)eflective of the Manager’s Views–Fail
To construct these target-return portfolios, managers typically use either historical returns, capital market assumptions, or a combination of both to build a multi-asset portfolio they expect will hit the overall return target with the minimum amount of volatility.
Even if a manager had an incredible track record of forecasting asset-class returns, which most do not, the available mix of asset classes in a daily liquidity vehicle might not add up to the total return target or may far exceed it over any particular time period.
Although expected returns are likely to change over time, target-return goals do not fluctuate based on market conditions, at least not that we’ve seen.
As with the Measurability requirement, as long as the target return is stated in advance, it is easy to hold a manager accountable for meeting or not meeting the goal over a reasonable time period.
(I)nvestable at a Low Cost–Fail
One cannot simply walk into a mutual fund store and purchase a low-cost and diversified investment that offers cash plus X% whenever one feels like it. Target-return funds don’t come cheaply either. The average target-return fund has a prospectus net expense ratio of 1.70%.
Active Fund Management Is Hard
Remember, mostly actively run funds underperform their respective indices. Using the SAMURAI test before making your investments can help you make better investment choices. Or you could always conduct a fun experiment like I did with the Financial Samurai fund and make up your own fund to try and beat the S&P.
Take a look at the 10-year performance chart below by investment style to see the proof. If professional money managers mostly underperform, there's even less of a chance for the rest of us.
Here are some additional articles for further reading.
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About the Author: Sam began investing his own money ever since he opened an online brokerage account in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at two of the leading financial service firms in the world. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate.
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