Mutual fund analysis typically consists of a very basic analysis of the fund's strategy (growth or value), median market cap, rolling returns, standard deviation and perhaps a breakdown of its portfolio by sector, region, etc. As investors, we often settle for statistical results without questioning the underlying drivers of those results, which in many cases can reveal some very interesting details.

The following summary does not promote the elimination of statistical performance analysis and evaluation of risk metrics, but rather advocates that it those analyses are supplemented with a more rigorous process that better addresses a manager's skill and value adding capabilities. Read on to find out how each of the metrics discussed below can be calculated and interpreted using a variety of different software. (For more, check out Analyzing Mutual Fund Risk.)

Monthly Performance
As in most cases, the first item of interest is a mutual fund's performance. We can look at rolling one-, three- and five-year returns versus both a benchmark and comparable peers, and find a number of managers that performed well. What we don't typically gather from this type of analysis is whether a manager's performance was consistent throughout the period being evaluated or if performance was driven by a few outlier months. We also don't know if the manager's performance was driven by exposure to certain types of companies or regions. By evaluating monthly performance versus a relative benchmark, we can find clues that provide additional insight into the performance expectation of a particular fund.


The best way to perform this analysis is to list the performance of the fund and the benchmark side by side and compare the relative over/under performance of the fund for each month and look either for months where the relative over/under performance was much greater or smaller than the average or to look for certain patterns of over/under performance. You may also look for months when performance was extremely high or low, regardless of the performance of the benchmark. For example, a mutual fund that mimics the index for 11 out of 12 months but outperforms the index by 3% in one month will have a very attractive one year return. As an investor, it would be key to understand the specific month's performance and not only what drove it, but whether it is repeatable. In other words, does the fund manager have a disciplined, methodical process in place that can continue to uncover good investment opportunities.

Many times, a fund manager cannot articulate their strategy or process, raising doubts as to whether they can actually repeat performance in the future. If any of these scenarios are found or any other instances of a performance anomaly, they can be great topics to bring up during the interview with the fund manager. (For more on assessing your fund manager, read our related article Assess Your Investment Manager.)

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Up Capture / Down Capture
This analysis uncovers the fund's sensitivity to market movements in both up and down markets. All else equal, the fund with higher up-capture and lower down-capture will be more attractive than other funds. There are cases when an investor may prefer one over the other, but for simplicity, I will focus strictly on these two measures as they relate to each other as well as a fund's peers.


Both of these measures are indicated as a percentage of the index. For example, a fund with an up-capture ratio of 110% will, on average have a return of 1.1% for every 1% return for the index. On the other hand, a down capture ratio of 70% will, on average, have a return of -0.7% for every 1% that the index is down. The goal is to find mutual funds that have up capture ratios greater than the down capture ratios. Over the long run, these funds will outperform the index.

If a fund has a high up-capture ratio, it would be more attractive during market rises than a fund with a lower up-capture ratio. This can result from investments in higher beta stocks, superior stock picking, leverage, or a combination of different strategies that will outperform the market when the market is rising. More often than not, mutual funds with high up-capture ratios also have higher down-capture ratios, which translates into higher volatility of returns. A good mutual fund manager, however, can become defensive during market downturns and preserve wealth by not capturing a high proportion of the market decline.

Lower down-capture can be realized by investing in lower beta stocks, superior stock picking, holding greater amounts of cash, or a combination of different strategies. The idea of both up-capture and down-capture metrics is to understand how well a mutual fund manager can navigate the changes in the business cycle and maximize returns when the market is up, while preserving wealth when the market is down. (For more information, read Does Your Investment Manager Measure Up?)

Calculating the Metrics
There is software in the marketplace that can calculate these metrics, but you can use Microsoft Excel to calculate both metrics by following these steps:


  1. Calculate the cumulative return of the market only for months when the market had positive returns.
  2. Calculate the cumulative return of the fund only for months when the market had positive returns.
  3. Subtract one from each result and divide the result obtained for the fund's return by the result obtained for the market's return.
To calculate the return for down-capture, repeat the above steps for months when the market went down.

Note that even if the fund had a positive return when the market went down, that month's return for the fund will be included in the down-capture calculation and not the up-capture calculation.

This reveals the following:

  • Asset Allocation: How well the manager can overweight or underweight certain positions in order to outperform the stated benchmark.
  • Security Selection: The manager's skill at selecting individual securities that outperform the market benchmark. (Learn three other ratios that will help you evaluate your investment returns in Measure Your Portfolio's Performance.)
Style Analysis
So, as an investor you have gone through both quantitative analysis and researched the mutual fund's investment strategy, its ability to outperform the market, consistency through good times as well as bad, and a variety of other factors that make an investment in the fund a good possibility. Before making an investment, however, an investor will want to perform a style analysis to determine if the mutual fund manager had return performance that was consistent with the fund's stated mandate and investment style. For example, style analysis could reveal whether a large cap growth manager had performance that was indicative of a large cap growth manager, or, if the fund had returns that were more similar to investments in other asset classes or in companies with different market capitalization.


One way to do this is to compare the monthly returns for the mutual fund with a number of different indexes that are indicative of a certain investment style. This is called a style analysis. In the example below, we compare the returns of Janus Advisor Forty Fund (JARTX) to four different indexes. The choice of indexes can vary depending on the fund being analyzed. The X axis reveals the correlation of the fund to international indexes or US based indexes. The Y axis shows the fund's correlation to large cap companies versus small cap companies. The indexes representing the US were the S&P 500 and the Russell 2000, while the international indexes were the MSCI EAFE and MSCI EM index. The data points were calculated using an optimization formula in Excel and applying it using the solver function.

We can see from the chart, JARTX had an increasingly strong correlation with the S&P 500 Index, which is consistent with their large cap focus. However, the most recent data points continued to move towards the left, indicating that perhaps the mutual fund manager was investing in a larger percentage of international companies.

Figure 1: Mutual Fund Analysis
The small diamond represents the similarities of mutual fund returns with each of the four indexes for the five-year period ending four quarters prior to the most recent month end. Each subsequently larger diamond calculates the same metric for the five-year rolling period for each subsequent quarter end. The largest diamond represents the most recent five-year rolling period. In this example, the fund increasingly behaved like a global fund rather than a U.S. large cap fund. The larger diamonds moved to the left in the chart, indicating very large cap with both U.S. and international companies.

This trend isn't necessarily a good or bad thing, it merely gives the investor another piece of information on how this fund generated its returns and perhaps more importantly, how it should be allocated within a diversified portfolio. A portfolio that already has a large allocation to international mega-cap equity for example may not benefit from the addition of this fund. (To learn more, read Don't Panic If Your Mutual Fund Is Drifting.)

Conclusion
Traditional mutual fund analysis, which you can find in a Morningstar report or Yahoo! Finance, can be a valuable tool to determine a fund's attractiveness relative to its peers. However, more detailed analysis can enable an investor to better evaluate a manager's skill relative to their mandate and more efficiently manage portfolios to desired exposures. The analysis can require more time spent on data preparation, but the benefits obtained from the additional information are well worth the effort. There are a number of additional metrics and qualitative factors that an investor can evaluate to determine a mutual fund's performance record and attractiveness. This article has merely provided a few additional tools that can be easily calculated yet provide very useful information.




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