How to Analyze Mutual Fund Performance

Don't Overlook Performance History When Buying Mutual

Funds
• Share
• Pin
• Email

•••
BY KENT THUNE

Updated September 28, 2018

Past performance of a mutual fund may not be a guarantee of future results but if you
know how to analyze fund performance -- if you know what to look for and what to avoid
-- you can make better investment decisions, which can increase the odds that future
performance will meet or exceed your expectations.

Apples to Apples: Compare Funds to Appropriate Benchmarks

The first piece of information to analyze with mutual fund performance is the fund's
returns compared to an appropriate benchmark. For example, if you want to see how
well you fund is performing, it's best to compare it to the average return for funds in the
same category.

Let's say you look at your 401(k) statement and notice that one of your funds had a
large decline in value but the others have performed well in a given time frame, this is
no indication that the declining fund should be removed from your portfolio. Look
at mutual fund types and categories first to understand if other funds in the category
have had similar performance.

You may also use an index for a benchmark. For example, if the fund is a large-cap
stock fund, a good benchmark is the S&P 500. If the S&P 500 declined 10% during the
period you are analyzing but your fund declined 8%, you may not have reason for
concern over the performance of your fund.

Know When Good Fund Performance Can Be Bad

If you are investing in a mutual fund, especially a stock fund, it is likely you plan to hold
it for at least three years or more. Making this assumption, there is rarely a need to look
at time periods of less than three years. However, this is not to say that short-term
returns, of say 1 year, are irrelevant. In fact a 1-year return for a mutual fund that is
incredibly higher compared to other funds in its category can be a warning signal.

Yes, strong performance can be a negative indicator. There a few reasons for this: One
reason is that an isolated year of unusually high returns is abnormal. Investing is a
marathon, not a race; it should be boring, not exciting. Strong performance is not
sustainable. Another reason to stay shy from high short-term performance is that this
attracts more assets to the fund.

A smaller amount of money is easier to manage than larger amounts. Think of a small
boat that can easily navigate the shifting market waters. More investors mean more
money, which makes for a larger boat to navigate. The fund that had a great year is not
the same fund it once was and should not be expected to perform the same in the
future.

In fact, large increases in assets can be quite damaging to a fund's prospects for future
performance. This is why good fund managers close funds to future investors; they can't
navigate the markets as easy with too much money to manage.

Understand and Consider Market and Economic Cycles

Talk to 10 investment advisors and you'll likely get 10 different answers about what time
periods are most important to analyze to determine which fund is best from a
performance perspective. Most will warn that short-term performance (1 year or less)
won't tell you much about how the fund will perform in the future. In fact, even the best
mutual fund managers are expected to have at least one bad year out of three.
Actively-managed funds require managers to take calculated risks to outperform their
benchmarks. Therefore, one year of poor performance may just indicate that the
manager's stock or bond selections have not had time to achieve expected results.

Focus on the 5 and 10-year Periods for Mutual Fund Performance

Just as some fund managers are bound to have a bad year from time to time, fund
managers are also bound to do better in certain economic environments, and hence
extended time frames of up to three years, better than others.

For example, perhaps a fund manager has a solid conservative investment philosophy
that leads to higher relative performance during poor economic conditions but lower
relative performance in good economic conditions. The fund performance could look
strong or weak now but what may occur over the next 2 or 3 years?

Considering the fact that fund management styles come in and out of favor and the fact
that market conditions are constantly changing, it is wise to judge a fund manager's
skills, and hence a particular mutual fund's performance, by looking at time periods that
span across differing economic environments.

For example, most economic cycles (a full cycle consisting of both recessionary and
growth periods) are 5 to 7 years in time duration. Also, over the course of most 5- to 7-
year periods, there is at least one year where the economy was weak or in recession
and stock markets responded negatively. And during that same 5 to 7-year period there
is likely at least 4 or 5 years where the economy and markets are positive. If you are
analyzing a mutual fund and its 5-year return ranks higher than most funds in its
category, you have a fund worth exploring further.

Use Weights to Measure Fund Performance

Common time periods for mutual fund performance available to investors include the 1-
year, 3-year, 5-year and 10-year returns. If you were to give heavier weights (more
emphasis) to the most relevant performance periods and lower weights (less emphasis)
to the less relevant performance periods, your humble mutual fund guidesuggests
weighting the 5-year heaviest, followed by the 10-year, then 3-year and 1-year last.

For example, you could create your own evaluation system based upon percentage
weights. Let's say you give a 40% weight to the 5-year period, a 30% weight to the 10-
year period, a 20% weight to the 3-year period and a 10% weight to the 1-year period.
You can then multiply the percentage weights by each corresponding return for the
given time periods and average the totals. You can then compare funds to each other.

The simple way to do this is to use one of the best mutual fund research sites and do
your search based upon 5-year returns, then look at the other returns once you've found
some with good potential. This weighting and/or search method assures that you will
choose the best funds based upon performance that gives strong clues about future
performance.

Don't Forget About Manager Tenure

Manager tenure must be analyzed simultaneously with fund performance. Keep in mind
that a strong 5-year return, for example, means nothing if the fund manager has been at
the helm for only 1 year. Similarly, if the 10-year annualized returns are below average
compared to other funds in the category but the 3-year performance looks good, you
might consider this fund if the manager tenure is approximately 3 years. This is because
the current fund manager receives credit for the strong 3-year returns but does not
receive complete blame for the low 10-year returns.

Putting all of the above factors together, you can make smart decisions about buying
the best mutual funds for your portfolio.

Disclaimer: The information on this site is provided for discussion purposes only, and
should not be misconstrued as investment advice. Under no circumstances does this
information represent a recommendation to buy or sell securities.

5 Ways to Measure Mutual Fund Risk

• FACEBOOK
• TWITTER
• LINKEDIN

BY CAROLINE BANTON

Updated Mar 27, 2019

There are five main indicators of investment risk that apply to the analysis of
stocks, bonds and mutual fund portfolios. They are alpha, beta, r-squared,
standard deviation and the Sharpe ratio. These statistical measures are historical
predictors of investment risk/volatility and they are all major components
of modern portfolio theory (MPT). MPT is a standard financial and academic
methodology used to assess the performance of equity, fixed-income and mutual
fund investments by comparing them to market benchmarks. All of these risk
measurements are intended to help investors determine the risk-
rewardparameters of their investments. Here is a brief explanation of each of
these common indicators.

Alpha
Alpha is a measure of an investment's performance on a risk-adjusted basis. It
takes the volatility (price risk) of a security or fund portfolio and compares its risk-
adjusted performance to a benchmark index. The excess return of the investment
relative to the return of the benchmark index is its alpha. Simply stated, alpha is
often considered to represent the value that a portfolio manager adds or
subtracts from a fund portfolio's return. An alpha of 1.0 means the fund has
outperformed its benchmark index by 1%. Correspondingly, an alpha of -1.0
would indicate an under-performance of 1%. For investors, the higher the alpha
the better.

Beta
Beta, also known as the beta coefficient, is a measure of the volatility,
or systematic risk, of a security or a portfolio compared to the market as a whole.
Beta is calculated using regression analysis and it represents the tendency of an
investment's return to respond to movements in the market. By definition, the
market has a beta of 1.0. Individual security and portfolio values are measured
according to how they deviate from the market.

A beta of 1.0 indicates that the investment's price will move in lock-step with the
market. A beta of less than 1.0 indicates that the investment will be less volatile
than the market. Correspondingly, a beta of more than 1.0 indicates that the
investment's price will be more volatile than the market. For example, if a fund
portfolio's beta is 1.2, it is theoretically 20% more volatile than the market.
Conservative investors who wish to preserve capital should focus on securities
and fund portfolios with low betas while investors willing to take on more risk in
search of higher returns should look for high beta investments.

R-squared
R-squared is a statistical measure that represents the percentage of a fund
portfolio or a security's movements that can be explained by movements in a
benchmark index. For fixed-income securities and bond funds, the benchmark is
the U.S. Treasury Bill. The S&P 500 Index is the benchmark for equities
and equity funds.

R-squared values range from 0 to 100. According to Morningstar, a mutual fund

with an R-squared value between 85 and 100 has a performance record that is
closely correlated to the index. A fund rated 70 or less typically does not perform
like the index.

Mutual fund investors should avoid actively managed funds with high R-squared
ratios, which are generally criticized by analysts as being "closet" index funds. In
such cases, it makes little sense to pay higher fees for professional management
when you can get the same or better results from an index fund.

Standard Deviation
Standard deviation measures the dispersion of data from its mean. Basically, the
more spread out the data, the greater the difference is from the norm. In finance,
standard deviation is applied to the annual rate of return of an investment to
measure its volatility (risk). A volatile stock would have a high standard deviation.
With mutual funds, the standard deviation tells us how much the return on a fund
is deviating from the expected returns based on its historical performance.

Sharpe Ratio
Developed by Nobel laureate economist William Sharpe,
the Sharpe ratiomeasures risk-adjusted performance. It is calculated by
subtracting the risk-free rate of return (U.S. Treasury Bond) from the rate of
return for an investment and dividing the result by the investment's standard
deviation of its return. The Sharpe ratio tells investors whether an investment's
returns are due to wise investment decisions or the result of excess risk. This
measurement is useful because while one portfolio or security may generate
higher returns than its peers, it is only a good investment if those higher returns
do not come with too much additional risk. The greater an investment's Sharpe
ratio, the better its risk-adjusted performance.

The Bottom Line

Many investors tend to focus exclusively on investment returns with little concern
for investment risk. The five risk measures we have discussed can provide some
balance to the risk-return equation. The good news for investors is that these
indicators are calculated for them and are available on a number of financial
websites: they are also incorporated into many investment research reports. As
useful as these measurements are, when considering a stock, bond, or mutual
fund investment, volatility risk is just one of the factors you should be considering
that can affect the quality of an investment.