Measuring mutual fund performance

Abstract

As the global asset management industry has grown enormously in size, investors need sound measures of fund performance to compare the performance of various funds. The performance measurement industry itself has grown in popularity.Morningstar and Lipper Analytical Services lead the industry in the USA. Such services have emerged in other parts of the world as well. In this chapter, we provide an overview of various approaches to measuring fund performance. This chapter has the following objectives: • Describe the measurement of return and risk of a fund. • Describe how value at risk (VaR) can be calculated for funds. • Compare and contrast popular measures of fund performance like Sharpe ratio, Modigliani measure, Treynor's ratio, and Jensen's alpha. • Describe Morningstar's Star rating system. As pointed out in the overview chapter on mutual funds, they are now the preferred way for individual investors and many institutions to participate in the capital markets, and their popularity has increased demand for evaluations of fund performance. Many business publications now rank mutual funds according to their performance, and information services exist specifically for this purpose. There is no general agreement, however, about how best to measure and compare fund performance and on what information funds should disclose to investors. Risk and performance measurement is an active area for academic research and continues to be of vital interest to investors who need to make informed decisions and to mutual fund managers whose compensation is tied to performance. This chapter describes a number of performance measures. Their common feature is that they all measure funds' returns relative to risk. However, they differ in how they define and measure risk and, consequently, in how they define risk-adjusted performance. If one were to believe the advertisements in the print and television media about past returns and star rating, one would be convinced that there are hundreds of funds that can claim great performance. This is not the case whether it is in the USA or any other country. While it is important to consider measures of past performance, one should evaluate that performance against the market and economic environments. If the fund invests in stocks that are typically cyclical in nature (e.g., automobile and housing stocks), the fund's recent performance may reflect the height of a cycle and not the future downturn of the business cycle. In addition, market volatility may affect short-term performance. Although past performance is certainly not an indication of future results, there are some clues to be found about the quality of a fund by correctly measuring its past performance. Usually, what will be discerned through a careful study of past performance is that not many mutual funds actually deliver anything close to what their advertisements claim. In the following sections, we describe: • Simple measures of fund return • Measures of risk • Risk-adjusted performance, and • Measures of risk and return based on modern portfolio theory. © 2009 Springer-Verlag Berlin Heidelberg.