Fin 367 Investment Management 03275

MEASURES OF MUTUAL FUND

PERFORMANCE

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The purpose of this paper is to give a description of the main measures of mutual fund performance. I

start talking briefly about what is a mutual fund, then I present different risk measures as well as return

measures separately. Finally, I will show the risk-adjusted performance measures used in the valuation of

the active managed mutual funds.

MUTUAL FUNDS

A mutual fund share represents a proportional ownership of all the underlying securities in the fund. A

mutual fund is more diversified than a typical individual's portfolio, thereby reducing the unsystematic

portion of risk. The amount of capital needed to obtain this diversification is too large for the average

individual investor. Besides, mutual funds can achieve economies of scale in trading and transaction

costs, economies unavailable to the typical individual investor. In addition, professional money managers

should be able to earn above average returns through successful securities analysis.

Factors affecting mutual funds performance

Expense Ratio Mutual funds charge fees basically, the management fee used to pay the manager of the

mutual fund. This is usually taken annually as a percentage of the fund's assets. Administrative costs are

also included.

Distribution fee. This fee (12b-1) is spent on marketing, advertising and distribution services.

Front-end/Back-end loads Commissions paid when you purchase/redeem the shares.

Risk. The greater the stock volatility or risk is, the higher the reward must be.

RISK MEASURES

Tracking Error Volatility Measures how closely an asset manager’s portfolio performance is versus the

market. Tracking error is simply the standard deviation of the portfolio’s active return, where active

return is defined as the difference between the portfolio return and the benchmark return.

Downside Risk Measures the probability-weighted squared deviations of all the returns below a specified

target return. It distinguishes between "good" and "bad" returns by assigning risk only to those returns

below the goal, missing the predetermined target.

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Standard Deviation Measures the dispersion of the outcomes around the expected return. It measures the

total risk of the portfolio. The higher the standard deviation of an investment's returns, the greater the

relative risky because of uncertainty in the amount of return.

Sharpe's Beta Describes how the expected return of a portfolio is correlated to the return of the market as

a whole. It is a measure of the portfolio's systematic risk.

RETURNS MEASURES

Time Weighted Rate of Return Measures how much the combination of the fund's manager investment

choices yielded on average, without the influence of the size and timing of investors' contributions or

withdrawals. This measure is used when you want to see how the manager investment choices, taken

together, returned compared to an index.

Dollar Weighted Rate of Return Measures how much the dollars you invested in the mutual fund

returned on average. This measure is used when you want to see if your return is above or below your

long term return objective. You will need to know the beginning balance, the date and the amount of your

every contribution and withdrawal, if any, and the ending balance.

RISK-ADJUSTED PERFORMANCE INDICATORS

Before 1960, investors evaluated portfolio performance almost entirely on the rate of return, although

they knew that risk was a very important variable in determining investment success, due to the lack of

knowledge how to measure and quantify it. After the development of portfolio theory in early 60s, and

CAPM in subsequent years, risk was included in evaluation process, leading to risk adjusted performance

indicators.

Treynor’s performance index:

Treynor =
( Rp − Rf )
βp

where Rp= portfolio rate of return

Rf= risk-free rate of return
β p= beta of the portfolio
Treynor measures portfolio risk with beta, and calculates portfolio’s market risk premium relative to its

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beta. Whenever Rp> Rf and βp > 0 a larger T (Treynor's ratio) value means a better portfolio for all

investors regardless of their individual risk preferences. In two cases we may have a negative T value:

when Rp < Rf or when βp < 0. If T is negative because Rp < Rf, we judge the portfolio performance as

very poor. However, if the negativity of T comes from a negative beta, fund’s performance is superb.

Finally when Rp- Rf, and βp are both negative, T will be positive, but in order to qualify the fund’s

performance as good or bad we should see whether Rp is above or below the security market line

pertaining to the analysis period.

Sharpe’s Performance index

Sharpe =
( Rp − Rf )
σp

where Rp= portfolio rate of return

Rf= riskfree rate of return
σ p= portfolio standard deviation
It is another measure of how well a fund is rewarded for the risk it incurs. The risk measure here is the

standard deviation; it means that it considers the total risk of the portfolio, systematic and unsystematic.

When comparing two portfolios, each with the expected return against the same risk-free rate of return,

the portfolio with the higher Sharpe ratio gives more return for the same risk. Investors of course should

pick investment with high Sharpe ratios in relation to their risk-aversion. The index is very similar to the

Treynor measure, the only difference is the use of standard deviation, instead of beta, to measure the

portfolio risk (i.e. the total risk of the portfolio rather than just the systematic risk).This formula suggests

that Sharpe prefers to compare portfolios to the capital market line (CML) rather than the security market

line (SML). Sharpe index, therefore, evaluates funds performance based on both rate of return and

diversification. For a completely diversified portfolio, Treynor and Sharpe indices would give identical

rankings.

Jensen’s Alpha

αp = µp − [ rf + βp ⋅ ( µm − rf ) ]

where µ p= expected total portfolio return

rf= risk-free rate of return
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 µ m= expected market return
β p= beta of the portfolio
µp = rf + βp ( µm − rf ) + e p
assuming the CAPM is empirically valid, we have that risk premium earned

on portfolio p is equal to the market risk premium multiplied by βp plus a random error term. In this

form, an intercept for the regression equation is not expected, if all securities are in equilibrium.

However, if certain superior portfolio managers can persistently earn positive risk premiums on their

portfolios, the error term ei will always have a positive value. In such a case, an intercept value which

measures positive differences from the model, must be included in the equation as follows

µp − rf = αp + βp ( µm − rf ) + e p
. Jensen uses αp as his performance measure. A superior portfolio

manager would have a significant positive αp value because of the consistent positive residuals. Jensen

performance criterion, like the Treynor measure, does not evaluate the ability of portfolio managers to

diversify, since the risk premiums are calculated in terms of β. If the value is positive, then the portfolio is

earning excess returns. In other words, a positive value for Jensen's alpha means a fund manager has

beaten the market with his stock picking skills.

Information Ratio

information ratio=excess return/tracking error

excess returns are defined as the return on the fund less the return on a benchmark. This is the fund’s

added value relative to the benchmark. The standard deviation of the excess returns is the tracking error.

Tracking error gives us an estimate of the risk the manager takes in deviating from the benchmark. This

ratio is called the information ratio because it focuses on the risk and return generated from the manager's

ability to use his information to deviate from the benchmark. A higher information ratio indicates a higher

degree of manager skills. The information ratio is particularly versatile as we can specify any benchmark.

If we specify the benchmark to be cash then the Information Ratio is almost the same as the Sharpe Ratio.

The value of the ratio depends crucially on the benchmark selected.

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Sortino Ratio

Rp − Rbenchmark
sortino =
Downside .risk

where Rp= portfolio return

Rbenchmark= benchmark return
Downside risk= downside only deviation relative to the benchmark
The justification for this ratio is that there is a minimum return that must be earned to accomplish some

goal. Any return below this benchmark is an unfavorable outcome. Risk is associated only with

unfavorable outcomes, so it penalizes only those returns falling below the investor’s target, or required

rate of return. It differs from the Sharpe ratio that penalizes both upside and downside volatility equally;

therefore, it is a more realistic measure of risk-adjusted returns.

Modigliani Modigliani measure

M2= Rp*-Rm
where Rp*= adjusted portfolio that have the same standard deviation as the index
Rm= market(index) return
Because the market index and the portfolio P* have the same standard deviation, we may compare their

performance simply by comparing returns. Basically, for a fund with any given risk and return, the

Modigliani measure is equivalent to the return the fund would have achieved if it had the same risk as the

market index. Thus, the fund with the highest Modigliani measure, like the fund with the highest Sharpe

ratio, has the highest return for any level of risk. Since their measure is expressed in percentage points

Modigliani and Modigliani believe that it can be more easily understood by average investor.

CONCLUSION

Of course, I think that traditionally used methods of evaluation (i.e. return measures, above) are not

accurate indicators of performance, because these approaches fail to adjust for the risk of a mutual fund.

Regarding the risk adjusted performance measures, the best to choose depends only on the investors’

characteristics: what they perceive as risk (i.e. if they consider risk only downside deviation from a target

return or the entire standard deviation of the returns) and their investment strategy (i.e. if all their wealth

is invested in just one asset or they hold a diversified portfolio). Nowadays investors have several useful

tools to analyze and choose the investments that better fit their needs. Invesors are thus more conscious
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and rationale in their investment decisions, with a positive effect on the efficiency of the market.

References

 Essential of Investments Author(s): Zvi Bodie, Alex Kane and Alan J.Marcus Published by:

McGraw-Hill Irwin

 L’economia del mercato mobiliare Author(s):P.L.Fabrizi Published by: Egea, Milano, 2006

 Asset Allocation: Management Style and Performance Measurement, by William F. Sharpe,

Journal of Portfolio Management, Winter 1992, pp.7-19

 Appunti sulla stima dei modelli lineari Author(s): Sandra Fortini, Università Bocconi, Milano