How to Gauge Mutual Fund Performance

One of the important things to consider when evaluating mutual fund performance is how efficiently cash assets are spread across different industries. Several studies show that approximately forty percent of variation in returns across funds is explained by target asset allocations. Ninety percent of the variation in a single portfolio can be explained by asset allocation within the fund. This illustrates that fund performance has less to do with individual equities comprising them then it does the actual differences in returns among asset classes. Recognizing efficient diversification when comparing funds is essential to selecting the best choices for investment. A perfectly diversified portfolio will optimize returns (i.e. provide the highest returns at a given level of risk) because of the inherent nature of equity risk itself. Equity’s total risk is comprised of systematic (market) risk and unsystematic (diversifiable) risk. Systematic risk cannot be avoided and is caused by stock market volatility stemming from macroeconomic factors. It is the beta of a stock, which measures how a stock moves in relation to the market. An investor is awarded a risk premium above the risk-free interest rate in return for taking on this inherent risk. Because owning an individual stock does not diversify, however, they also experience unsystematic risk and are likely to have their stock value fluctuate with the performance of the company and its industry. Diversifiable (unsystematic) risk can be minimized and in some cases eliminated through proper diversification.

How to Properly Diversify

One valuable concept to apply when selecting mutual funds is that a great amount of equity holdings does not necessarily translate into more efficient diversification. As few as fifteen or twenty equities may be sufficient if properly correlated. The best mutual funds allocate assets among industries that have low correlations with each other. A lower asset correlation means better fund performance. This is because assets moving opposite each other offset volatility. Be aware of correlation when evaluating industries held by funds. Although determining actual correlation of a fund involves lengthy mathematics, it is useful to logically reason whether fund-held industries would be positively or negatively correlated with each other (for example, the oil services and energy sectors would exhibit a high degree of correlation, whereas the correlation between the real estate and energy sectors might be less direct, and thus lower). 

Skewed Results

Survivorship bias is another concept to keep in mind when evaluating historic performances of mutual funds. This is an upward bias of overall mutual fund performance that occurs because the funds we are reviewing are the ones that have “survived” (i.e. did not go out of business) over the years. In reality, more funds have gone out of business then have survived, and when evaluating historical averages of mutual fund performance, we are essentially evaluating the best funds, while excluding the returns of all the funds that did not last. Overall, the most important lesson to take home is that effective diversification among asset classes, characterized by low correlations between assets is the key to choosing the best funds out there.