Mutual Funds come with their own share of risks but they are also one of the best ways to grow your wealth. However, they also carry various expenses that reduce your take-home returns.
The Fama-French model has long been the gold standard for mutual fund performance analysis. It expands on the capital asset pricing model by adding company size and value risk factors.
1. Historical Returns
Like Doppler radar or quarterback ratings, mutual funds come with a disclaimer: Past performance does not guarantee future results. But understanding a fund manager’s track record is essential to making sound investment decisions.
Using data on 151 equity mutual funds in continual operation, this study explores the long-run relationship between gross return and asset size, expense ratios, portfolio turnover, and load/no-load status. It also employs a pooled cross-section/time series analysis to account for survivorship bias and to estimate transaction costs.
The potential costs over time illustrated for each selected fund include front-loads, back-loads, 12b-1 fees, and annual operating expenses. The projected account value and total cost reflect deduction of these costs. The fund with the lowest projected cost for your scenario, based on your holding period and rate of return is highlighted. The actual after-tax returns may vary from those shown due to differing tax rates. Please consult your tax advisor to determine the impact of taxes.
2. Risk-Adjusted Returns
A fund’s risk-adjusted returns are a better measure of its performance than raw or net returns. These include measures such as standard deviation, beta, R-squared and Jensen’s alpha. It’s important to evaluate these metrics over a long period to get the best picture of how a fund has performed.
It’s also essential to consider the impact of expenses and turnover when evaluating risk-adjusted returns. Research shows that higher expenses and turnover lead to lower risk-adjusted returns. It is also important to consider the effect of manager qualifications and goodwill on a fund’s performance.
Finally, it’s vital to consider a fund’s consistency in return over time. This can be measured with information ratios, such as the five-year information ratio. A high information ratio indicates a consistent track record. It is also important to look at a fund’s stock selection skill and portfolio differentiation, which can be measured with measures such as Jensen’s Alpha and the R2 statistic.
3. Performance Ratios
A fund’s performance ratios indicate how much additional return the manager has generated compared to how risky the fund is. They can also be a good way to compare the quality of a fund’s management. A higher Sharpe Ratio means a greater excess return for a given level of total risk.
One key metric is the fund’s annual expense ratio, which accounts for fees that are deducted from the funds total net asset value (TNA). This figure includes management fees, distribution and marketing/12b-1 fees, investor transaction fees, and various other costs.
Previous research assumes that a single equation regression model can describe the relationship between expense ratios and performance, but these models suffer from pronounced heteroscedasticity. For example, while OLS regressions show that high-performing funds tend to have lower expenses, the scatter plot in Panel A of Table 1 shows a marked dispersion of fund performance, which the OLS model fails to capture. The quantile regression coefficients reported in Table 3 reflect this.
4. Manager’s tenure
A fund’s manager’s tenure is an important factor to consider. Often, the longer a manager has been at a given fund, the better it tends to perform.
The reason behind this is that experienced managers have learned how to navigate the ups and downs of the market, and how to best optimize their portfolios. They also know how to effectively select securities for their funds and can make the most of the investment opportunities available in the markets.
In addition, the longer a manager has been at the helm of a fund, the more stable their performance is likely to be. The inverse is true as well: funds with unstable managers tend to underperform.
Another thing to look for in a fund’s manager is their turnover ratio. This measure indicates how frequently the fund’s manager buys and sells securities, which can impact your take-home returns through increased transaction fees. A lower portfolio turnover ratio is therefore preferable.
