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.

Key Takeaways

  • Traditional mutual fund analysis can be a valuable tool to determine a fund's attractiveness relative to its peers.
  • Evaluating a fund manager on a longer time horizon is a more viable research method versus focusing only on their 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.

Monthly Performance

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. (See also: Analyzing Mutual Fund Risk.) 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. (See also: Assess Your Investment 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 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 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. (See also: 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:

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. The returns of Janus Advisor Forty Fund (JARTX) to four different indexes in the below example. 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 U.S.-based indexes.

The Y-axis shows the fund's correlation to large-cap companies versus small-cap companies. The indexes representing the U.S. 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.

Figure 1: Mutual Fund Analysis

As is evident in 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 toward the left, indicating that perhaps the mutual fund manager was investing in a larger percentage of international companies.

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 a 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. (See also: Don't Panic If Your Mutual Fund Is Drifting.)