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Blogs written
by our financial economists on mutual funds and mutual fund investing
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What to look for in a mutual fund
The short answer: Positive risk-adjusted returns, stable risk exposures, long
management tenure, diversification and moderate turnover.
• Positive risk-adjusted returns, or alphas. A fund with positive alphas adds
value by delivering returns in excess of those expected from the fund given the
fund's risk exposures. In contrast, a fund with zero alphas behaves like an
index fund by earning returns exactly commensurate with the amount of risk it is
taking on. A fund with negative alphas underperforms by earning returns which
don't compensate investors for the risk they are exposing themselves to by
investing in the fund and therefore a negative-alpha fund should be generally be
avoided.
• Stable risk exposures (consistent investment style). A fund's risk is
generated by its exposures to risk factors in stock and bond markets. Drift or
shift in a fund’s risk exposures over time may indicate an inconsistent
investment strategy. Also, a fund with drifting or shifting risk exposures tends
to contribute more risk to an investor's overall portfolio than a fund with
consistent exposures.
• Management tenure. AlphaFunds evaluates a fund using at least 36 months of
historical data. We can expect the evaluation to be more informative if the
fund's management team has not changed over the evaluation period (after all,
how much faith would we have in an assessment of a fund based on the fund's
track record over the prior 5 years if the management team changed last
quarter?). This suggests requiring a fund's management tenure to be at least 36
months.
• Diversification. A diversified fund has exposure only to market risk while an
undiversified fund has exposure to both market risk and non-market risk. Since
exposure to non-market risk is not compensated, a fund with exposure to only
market risk (a fund which is diversified) tends to be less risky than a fund
with exposure to both market and non-market risk. One way to increase the chance
of diversification is to require funds to have at least 50 positions.
Note that the more funds your portfolio contains, the less important it is for
each fund to be diversified. This is because the other funds in your portfolio
will diversify away the non-market risk in any undiversified fund. This is the
case even if all funds in the portfolio are undiversified. So if you are
building a portfolio of just one or two funds, your portfolio will not be
diversified unless each of the funds is diversified. However, if you are
building a portfolio with eight funds, your portfolio will probably be
diversified even if each of the funds in it is undiversified.
• Net assets. Funds with a larger amount of net assets have a higher chance of
being well-established than funds with a smaller amount of net assets. It
therefore may be prudent to require funds to have at least $100 million in net
assets.
• Turnover. For portfolios which are not tax-sheltered, funds which frequently
realize returns by selling stocks or bonds tend to be less tax-efficient than
funds which sell less frequently. One way to identify funds which are more
tax-efficient is to require funds to have a turnover rate which is below the
stock or bond fund median.
You can apply all these criteria by pressing the Apply Suggested Filters button
on the
FundScreener
page.
What is a fund's alpha?
For each fund we build a benchmark index with the same risk as the fund. A
fund’s alpha, which is another name for risk-adjusted return, is the return of
the fund minus the return of the fund’s risk-matching benchmark index.
• If a fund’s alpha is positive, the fund is earning returns in excess of those
expected given the amount of risk the fund is taking on. The fund is adding
value because it is earning returns higher than those an investor could earn by
investing in an index fund with the same risk.
• If alpha is negative, the fund is earning returns which don't compensate
investors for the risk the fund is taking on. So an investor good do better by
investing in an unmanaged index fund with the same risk as the fund. Funds with
negative alphas should generally be avoided.
• If alpha is zero, then the fund is earning returns exactly commensurate with
the quantity of risk it is taking on and therefore is behaving like an unmanaged
index fund.
Do mutual funds beat index funds?
The short answer: About 1 in 5 stock funds and about 1 in 3 bond funds beat
their index benchmarks by an economically significant amount.
The best way to evaluate how a mutual fund performs compared to an index is to
examine the fund's risk-adjusted returns, or alphas. Alpha is the difference in
returns between the fund and an unmanaged index which has the same risk as the
fund.
We can look at alphas on the Fund Screener page.
• In the Asset Class box, select the Stock Funds tab. In the Filters box,
select "Mainstream Domestic Equity" from the super category drop-down list
(thereby excluding Sector, Specialty and Foreign stock funds). This yields
5,295 funds. Next, select "> 1.00" in the alpha 60 drop-down list (you may have
to hit the more filters button first). This yields 1,175 funds. So 1,175 out
of 5,295, or slightly more than 1 in 5 mainstream US stock funds beat their
risk-matching benchmark indices by 1% or more per year over the prior 5 years.
• If we repeat this exercise for Mainstream Domestic Fixed-Income funds, we find
that 285 out of 1,955 funds have alphas of 1% or more per year. So about 1 in 7
mainstream US bond funds beat their benchmark indices by 1% or more per year.
Since the returns of bond funds are generally lower than the returns of stock
funds, we would expect bond funds' alphas to be lower than stock funds' alphas.
So let's instead count how many bond funds beat their benchmark indices by 0.50%
or more per year by selecting selecting "> 0.50" in the alpha 60 drop-down. We
find that 595 out of 1,955, or about 1 in 3 mainstream US bond funds beat their
benchmark indices by at least 50 basis points per year over the past 5 years.
The main message is that there are indeed mutual funds that outperform indices
by an economically significant amount. The challenge is to identify those
funds. This can be done by screening funds based on risk-adjusted returns, or
alphas.
How is a fund's score computed?
In order to summarize a mutual fund’s investment performance, AlphaFunds
constructs a score for each fund based upon the fund’s alpha, or risk-adjusted
return.
A fund’s score combines the (1) rank of its alpha, (2) rank of its alpha’s
signal-to-noise ratio and (3) rank of the proportion of months that its alpha is
positive.
Ranks are percent ranks (meaning they range between 1 and 100) and computed
within a fund’s style peer group. For a stock fund, the peer group contains all
the funds with similiar exposures to the size and valuation factors to those of
the fund (in other words, the peer group contains all of the funds that have a
similiar size and valuation investment style to that of the fund). For a bond
fund, the peer group contains all the funds with similiar exposures to the
duration and credit quality factors.
So a fund with a high score will generally have, relative to the funds with a
similiar investment style, a high alpha, a high alpha signal-to-noise ratio and
a high proportion of positive monthly alphas.
To receive a high score, a fund must consistently deliver high alphas. A fund
which produces an outsized alpha in one quarter (possibly by chance) and low or
negative alphas in other quarters will generally not receive a high score.
What are a fund's betas?
A fund's betas measure the fund's exposures to the risk factors in stock and
bond markets and therefore measure a fund's risk.
For example, a stock fund's size beta measures it exposure to the size factor in
returns. A fund with a large size beta has a high exposure to the size factor.
This tells us that the fund invests in small cap stocks. Similarly, a fund's
valuation beta measures its exposure to the valuation factor. A fund with a high
valuation beta has a high exposure to the valuation factor because it invests in
value stocks.
Hence, betas measure a fund's risk exposures which is the same as saying that
they measure a fund's investment strategy or investment style because they tell
what sort of stocks or bonds a fund invests in.
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