Mutual fund analysis typically consists of an elementary 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, and so on. Investors often settle for statistical results without questioning the underlying drivers of those results, which can yield information that could potentially result in higher profit.
- Traditional mutual fund analysis can be a valuable tool to determine a fund's attractiveness relative to its peers.
- Evaluating a fund on a longer time horizon is a more viable research method versus focusing only on its highs and lows.
- All mutual funds should be researched thoroughly to gauge their appetite for risk as well as their ability to outperform the market.
As in most cases, the first item of interest is a mutual fund's performance. You can look at rolling one-year, three-year, and five-year returns versus both a benchmark and comparable peers and find a number of managers that performed well. What you 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. You also won't know if the manager's performance was driven by exposure to certain types of companies or regions.
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/underperformance of the fund for each month and look either for months where the relative performance was much greater or smaller than the average or to look for certain patterns. You may also look for months when performance was extremely high or low, regardless of the performance of the benchmark.
By evaluating monthly performance versus a relative benchmark, investors can find clues that provide additional insight into the performance expectation of a particular fund.
Many times, a fund manager cannot articulate the strategy or process, raising doubts as to whether they can actually repeat performance in the future. If during an analysis this or other instances of a performance anomaly are found, they can be great topics to bring up with the fund manager.
Up-Market and Down-Market Capture
This analysis uncovers the fund's sensitivity to market movements in both up and down markets. All else equal, the fund with a higher up-market capture ratio and lower down-market capture ratio will be more attractive than other funds. Many analysts use this simple calculation in their broader assessments of individual investment managers. There are cases when an investor may prefer one over the other.
An investment manager who has an up-market ratio greater than 100 has outperformed the index during the up-market. For example, a manager with an up-market capture ratio of 120 indicates that the manager outperformed the market by 20% during the specified period. A manager who has a down-market ratio of less than 100 has outperformed the index during the down-market. For example, a manager with a down-market capture ratio of 80 indicates that the manager's portfolio declined only 80% as much as the index during the period in question. Over the long run, these funds will outperform the index.
If a fund has a high up-market ratio, it would be more attractive during market rises than a fund with a lower up-market 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.
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.
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:
- Calculate the cumulative return of the market only for months when the market had positive returns.
- Calculate the cumulative return of the fund only for months when the market had positive returns.
- 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.
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 also 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. A style analysis could reveal whether a large-cap growth manager had a 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. To do this, an investor would compare the monthly returns for the mutual fund with a number of different indexes that are indicative of a certain investment style and see how it compares in different key metrics.
A trend that emerges from the style analysis isn't necessarily a good or bad thing; it merely gives the investor another piece of information on how the particular fund generated its returns and, perhaps more importantly, how it should be allocated within a diversified portfolio.