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Digging deeper

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25 October 2019

David Prosser explains why you should look further than just the discount/premium of an investment company and take ‘Z scores’ and ‘Sharpe ratios’ into account during analysis.

An investment company whose shares currently trade on a 10 per cent discount to the value of its underlying assets offers better value than a similar fund on a 5 per cent discount, right? Maybe, but don’t assume the first fund is cheap right now; if, say, its discount averages 15 per cent over the longer term, you might reasonably conclude that it’s expensive.

Fund comparisons are fraught with such difficulties. No two funds, even in the same sector of the market, are identical. Comparisons between them may offer some clues about relative valuations, but they’ll only tell part of the story and can sometimes be outright misleading.

The truth is that there are no short-cuts. Advisers and investors picking investment companies need as much data as they can get to make informed decisions. Running the slide rule over the sector in which you’re interested will get you so far, but you need to dig a little deeper. Two bits of data, in particular, can help here.

First, have you looked at investment company Z scores? This handy little yardstick tells you how an individual fund’s current discount compares to its average discount over a longer-term period. Broadly speaking, a Z score of -1.5 or below suggests the fund is cheap by historical standards, while a rating of 1.5 or more is an indication that its expensive.

Context, as ever, is crucial. Some funds have historically traded in relatively narrow discount ranges, in which case their Z scores are unlikely to flag up anything significant one way or another. Also, there may be an important explanation for an out-of-sync Z score – a fund that loses its manager, say, is likely to slip to a wider discount and a more negative Z score, but you’ll want to take its operational changes into account before deciding whether it really is cheap.

Still, Z scores can be very useful. And so too can a second bit of data – a fund’s “Sharpe ratio”. This measure, named after the Nobel Prize for Economics winner William Sharpe, who developed it, provides intelligence on how well an investment company has performed relative to the risk to which it exposes investors.

The Sharpe ratio is calculated by stripping out the risk-free rate of return from the fund’s performance – what investors could have earned simply by plonking their cash in super-safe government bonds. Then it divides the performance remaining by the volatility of the returns achieved – how much they bounced around.

Broadly speaking, the higher the fund’s Sharpe ratio, the better its risk-adjusted performance. This is a backward-looking measure, of course, and the caveats about past performance’s reliability as a guide to the future are important here. Still, the Sharpe ratio is a good yardstick for assessing whether an investment company manager has been earning their money.

Taken together, these two data points can provide advisers with a useful screen for narrowing down fund choices. You’re looking for funds with high Sharpe ratios and very negative Z scores – these are vehicles that have historically performed well and which currently look attractively priced.

This is only part of the fund-picking process. Advisers will still need to make more subjective judgements about whether contextual factors undermine the signals from the data – and, of course, which types of fund are most suitable for the client’s investment aspirations, attitude to risk and existing portfolios. Nevertheless, this data can start to paint a vivid picture of which investment companies stand out from the crowd.