Mutual Funds: Evaluating Performance

The Morningstar mutual fund rating system started back in 1985, and was immediately embraced by advisors as well as investors. In 2002, Morningstar enhanced their rating system by introducing several new peer groups, and changing their measure of risk-adjusted return. The two major components of this new system include:

• Category Rankings: Funds are ranked within categories such as large value, large blend, world stock, and specialty funds. By ranking mutual funds relative to peers, investors get a better sense of relative performance.

• Risk Adjustments: Mutual funds are rated for risk with a greater emphasis on downward risk. That is, there is more emphasis placed on avoiding a negative outcome.

This risk adjustment component is important to understand. Morningstar uses a risk rating that is based on what is called utility theory. This theory states that investors are more concerned about possible negative outcomes than unusually high returns. Funds that perform extremely well one year, and poorly the next, will not be rated as highly as a fund returning moderately positive returns over the same period of time.

Five Star Ratings

The highest possible score in the Morningstar system is a five star rating. Funds are evaluated based on trailing three, five, and 10-year time periods whenever possible. The overall rating is a composite, or a weighted average, of these time periods. The exact formula for that weighting is:

Morningstar Rating Formulas

As the above table illustrates, Morningstar places more emphasis on a fund's longer-term performance whenever possible.

Distribution Ratings

Finally, it's worth mentioning how these mutual fund ratings are distributed within categories. Morningstar distributes stars based on relative performance, and the distribution is as follows:

• Five Star Ratings: 10.0% of mutual funds in a given category

• Four Star Ratings: 22.5% of mutual funds in a given category

• Three Star Ratings: 35.0% of mutual funds in a given category

• Two Star Ratings: 22.5% of mutual funds in a given category

• One Star Ratings: 10.0% of mutual funds in a given category

From the above information it should be clear that a five star rating means the mutual fund outperformed 90% of its peers competing in the same fund category.

Another important piece of information that can be used to evaluate mutual funds is their historical returns. This performance metric is usually stated in both absolute and relative terms. A chart of this information will usually show the actual performance of the fund over time, in addition to comparing that performance to peers, or an index.

For example, the chart might show what would have happened to a $10,000 investment over a five year span of time. The chart will also show what would have happened if the investor placed that money elsewhere; usually in a measure of overall market performance such as the S&P 500 Index.

Morningstar might also include a chart of other mutual funds competing in that same category. This allows the investor to visualize, and compare, the relative performance of the mutual fund versus the market and its peers.

Finally, there is oftentimes published a "% rank in category" figure. This value should be as high as possible because that number reveals how well that fund did relative to its competition. For example, a % rank in category figure of 95% means that only 5% of the funds in that category did better than the mutual fund being examined.

Volatility measures for mutual funds provide investors with a good feel for the stability of the fund from year to year. Typically, when looking at measures of fund volatility, the following measures are encountered:

• Standard Deviations

• Means or Averages

• R Squared versus a Standard Index

• Beta versus a Standard Index

• Bear Market Ranking

• Mutual Fund Alpha

• Sharpe Ratios

We're going to finish up this topic by explaining each of the above measures.

Standard Deviation

A fund's standard deviation is a measure of the range in the mutual fund's performance. The higher the fund's standard deviation, the greater is the risk of volatility. For example, when comparing two mutual funds with the same average return, the fund with the higher standard deviation had greater fluctuations in return from year to year.

Mean or Average

This is the mean, or average, return for this mutual fund over the time period stated. It's the same exact concept that was learned in school. Averages are usually stated in 3, 5, and 10 year lengths.

R-Squared versus a Standard Index

R-squared measures are usually stated in terms of percentages or values from 1 to 100%. This measure reveals how useful the beta value will be in predicting the movement of this mutual fund; this will be discussed in more detail later on.

R-squared versus a standard market measure, such as the S&P 500 Index, tells the investor how much of the fund's movement can be explained by the movement of the market. If a fund's R-squared value is 100%, then the fund moved up and down in-step with the S&P 500.

Beta versus a Standard Index

A mutual fund's beta versus a standard index tells the analyst the relationship between the fund's excess returns (relative to T-Bills), versus the excess return of the standard index. Most equity mutual funds are compared to the S&P 500 Index, while bond funds are compared to a bond index.

For example, if a mutual fund has a beta of 1.1, the fund has performed 10% better than the S&P 500 Index after deducting the T-Bill rate in a bull (rising) market. This also means the fund may be expected to under-perform the S&P 500 Index by 10% in a bear (falling) market.

Bear Market Rank

The bear market rank can be useful in determining how well a fund performed relative to its peers in a down or bear market. This figure is based on the total returns for those mutual funds during bear markets, and is stated on a percentile basis.

For example, if a fund has a bear market rank of 3, the fund was in the top 3% of its peer funds in terms of total return during a bear market. Mutual funds with a rank of 1 to 5 have withstood these downturns quite well, while a ranking of 95 to 100 means the fund has performed poorly relative to its peers.

Mutual Fund Alpha

The mutual fund alpha measures how well a fund performed relative to its expected performance. A positive alpha would indicate a fund performed better than beta predicted. A negative alpha indicates a fund performed worse than beta predicted.

For example, let's say a mutual fund had an alpha of 0.75, an R-squared of 0.95, and a beta of 0.90. The high R-squared value means the beta value should be fairly accurate. However, the alpha of 0.75 indicates the fund produced a return that was 0.86% higher than the beta predicted.

Sharpe Ratios

A Sharpe ratio is a risk-adjusted measure that was developed by Nobel Laureate William Sharpe. The Sharpe ratio is a measure of the excess returns for each unit of risk. The ratio is normally calculated using performance over the last 36 months. The Sharpe ratio tells the analyst how much excess return (relative to a risk-free investment) is returned for each unit of risk.

For example, let's say Bill is comparing a mutual fund to its peer category, and the fund's Sharpe ratio is 0.50, while its peer category is 0.30. This means one unit of risk returned 0.50 in excess returns for the fund, while the peer group only achieved 0.30 in excess returns. Therefore, the risk-adjusted reward for this fund is higher than its peer group.

Up Next: Mutual Fund Fees and Loads

This brings us to our final article in this four part series. Up next, we'll be discussing mutual fund management fees and loads.

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