How to find a good fund manager

The job of a professional fund manager is simple in theory. You have to beat the market. You have to make more money for your investors than they could have made by using a cheap tracker fund to follow the underlying market. But doing this in practice is far from easy.

And if you're an investor looking to find a manager who can actually deliver market-beating returns, you'll find that's a tough job too. Plenty of investment websites have fund-manager league tables. But how do you know if the latest hot fund or manager isn't just a flash in the pan? Is there really long-term skill involved, or just short-term luck?

You can't make any decent judgement about a fund manager's skill without considering risk. Risk and reward go hand in hand when it comes to investing. If you take big risks you want to be compensated with big profits. So what you really need to know as a potential fund investor is whether the manager is getting a decent return for the risks being taken.

The good news is that there is a way to measure this. In 1966, William Sharpe, one of the leading thinkers in academic finance, devised a way to adjust the returns a manager achieved to compensate for the amount of risk being taken. The measure came to be known as the Sharpe ratio.

Now, when Sharpe talks about risk, he is not talking about the risk of losing money, which is how you and I might think about it. He focuses on how volatile investments are how much they bounce around their average returns over a period of time. This is calculated by taking the standard deviation of a manager's return. The bigger the standard deviation, the riskier the fund.

This does make some sense. Investments that fluctuate a lot are riskier than those that don't. Volatility drives investors to overtrade and make mistakes selling in panic at market bottoms, and buying out of greed at tops. You feel great if you buy something before it shoots up, but feel terrible if it plunges as it might take years to recover. The stock market with its wild swings is much more risky than money sitting in the bank or in short-term government bonds.

The Sharpe ratio is based on the returns of a fund manager, less the returns from a risk-free asset, such as a developed-world government bond. This figure is then divided by the fund's standard deviation (how much it fluctuates) to get the Sharpe ratio. The higher the number, the more skilled the manager is deemed to be. A negative Sharpe ratio means the investor would have been better off in cash or bonds there has been no extra return for the risks that have been taken.

Let's say that fund manager Adam's UK equity fund has returns of 20%, and a standard deviation of 10%. His rival Bertha's fund has returns of 15% and a standard deviation of 5%. The risk-free rate is 5%. Which fund should you buy? In this case, Bertha wins. You should always try to get the highest returns, for taking the least amount of risk, and here that's Bertha. Her Sharpe ratio is two (15 minus five, divided by five). Adam's is 1.5 (20 minus five, divided by ten). Bertha is getting more out of her fund for each unit of risk.

Like most measures, the Sharpe ratio has some drawbacks. It can be manipulated by clever managers. It can also be distorted if a manager (hedge funds, for example) is using borrowed money (leverage) or derivatives such as options to boost returns. But its relative simplicity means it will remain a popular way of choosing good managers over those who are simply taking more risk. You can find data on Sharpe ratios and standard deviations on most fund literature, so you don't have to work it out yourself.

What should you buy now?

Standard Life's UK Equity Unconstrained fund has done exceptionally well over both one and three years, beating the other funds listed. However, that doesn't mean it is necessarily the best fund according to the Sharpe ratio, this fund has taken slightly more risk than the others to achieve its returns.

For those of you who like the low costs and simplicity of passive investing, the good news is that the iShares FTSE 250 ETF (LSE: MIDD) does very well on this measure. Not only has it outperformed the average managed UK equity fund over one and three years, its risk-adjusted returns as measured by its Sharpe ratio are quite respectable too, and better than some leading managed funds over three years. If you're prepared to pay for active management, two better bets than the Standard Life fund are the Invesco Perpetual Aggressive fund (which has the highest risk-adjusted return over one year) and Cazenove Opportunities (best over three years).