Should a Single Number Guide Your Investment Decisions?
Can you rely on one score to make smart investment decisions?
There's no denying the power of a single number. You use one number to assess other things, after all. Take your IQ, credit score and blood pressure, for example. A single number is simple and straightforward. Right?
Despite their appeal, single summary scores intended to crystallize a segment of market dynamics are only useful when taken in context.
Two scores, Fidelity's Equity Summary Score and Vanguard's Active Share, are increasingly being used by money managers to quickly evaluate the strength of a stock or fund. Here's why -- as well as what you need to know if you want to rely on these statistical summary scores.
Introduced in 2010, Fidelity's Equity Summary Score has gained momentum in the past 24 months, reports Franklin Gold, senior vice president of research and education for Fidelity. The score was designed in response to customers' queries about which research they should take more seriously: analysis generated by specialists or the all-things-considered recommendations produced by widely known research firms. The Equity Summary Score is adapted from an earlier "analyst accuracy score" used internally.
[See: 7 Myths About Dividend-Paying Stocks.]
"This was a way to synthesize the research to make it more usable," Gold says.
The methodology wraps myriad historical records and analyst comments and history into a single score for each stock. Analysts who have been right in the past get greater weight within the score. On a scale of 1 to 100, the bigger the number, the more bullish credible analysts are on the equity.
"When customers look at a '9,' they know what that means," Gold says. "It makes it easy for them to monitor stocks and see changes in analyst ratings." Once you are conversant in the score, you can use it to quickly see the change in value of stocks you own or are considering owning.
Vanguard's Active Share tells you how hands-on a fund manager actually is. The more hands-on the fund manager is, the greater the likelihood the fund will outperform.
On a scale of 1 to 100, an Active Share score of 60 percent or less indicates fund managers are so sufficiently hands-off that investors may as well be indexing. "For a mutual fund, if you're paying that higher expense ratio, you want to get something for it," says Matthew Pistorio, the Chicago-based head of retail research and analytics at Henderson Global Investors. "A higher Active Share indicates that the manager is actually active. The lower the score, the closer the fund is to the index."
[Read: Is There Such a Thing as Too Much Indexing?]
"Silver bullet" numbers like these are useful in two ways. You can use them to assess the movement and relative strength of stocks and funds. You can also use them as discussion points to better understand how your advisor makes investment decisions.
The Equity Summary Score and Active Share are only useful if you take the time to understand how they are built, company experts say.
As you dig into the underlying methodology, pay attention to the benchmarks embedded in the scores, says Ken Faulkenberry, founder of Arbor Investment Planner, an investing newsletter. Don't confuse recent performance with a validation of the methodology. It's relatively easy to demonstrate great results over the span of the recent bull market, so look beyond the last five years to assess how the indicator looked during the recession.
"Does this only tell you that stocks have done a really well in a bull market? That's not helpful," Faulkenberry says.
"It's a great starting point, and it's a great way to validate ideas," Gold says. "But it's not in and of itself a great way to look at stocks. You want to see how this fits into your investment style. This provides a way to start that research journey."
Once you understand the underpinnings of such scores, you can ask your advisor how he or she uses them -- or doesn't use them.
[Read: 10 Questions to Ask a Financial Advisor.]
How your advisor uses Active Share gives you insight into how hands-on your advisor will be with managing your portfolio. "Ask the advisor how he uses it in his practice," Pistorio says. If your advisor recommends funds with low Active Share scores, you will want to know why you shouldn't directly buy indexed funds, Pistorio adds.
Mark Travis, president of Intrepid Capital Funds, based in Jacksonville, Florida, says many advisors try to win results that track closely with index funds and scores. But if your advisor benchmarks his performance based on the widely available indicators, you probably aren't getting much independent thinking and analysis for the fees you are paying, he says.
"I don't think people should pay a high fee for something that could be automated," Travis says.
Pistorio says Henderson hunts for stocks that don't fall in line with industry norms. Scouting such stocks is exactly the kind of effort that typically results in a higher Active Share score. And, he adds, funds with higher Active Share scores usually have higher risk-adjusted returns.
Ask your advisor how he uses single-number scores -- as a jumping off point, or as a key measurement? The answer you want to hear, Travis says, is that your advisor has a dashboard of key indicators -- some well known, some not -- that provide direction for your goals.
