Learn how professionals analyze mutual funds
Analyzing Mutual Funds Using Statistical Measures
Analyzing mutual funds requires a basic understanding of quantitative measures such as beta, R-squared, alpha, Sharpe ratio, total expense ratio, and tax cost ratio:
Beta:
Beta, in relation to investing in mutual funds, is a measure of a particular fund’s movement (up and down) compared to the overall market. For example, the market beta is set at 1.00. If a fund has a beta of 1.10, this fund is expected to return 11% (1.10 is 10% higher than 1.00) in a rising market, but is expected to fall 11% when the market drops by 10%.
R-squared:
According to Morningstar, “R-squared reflects the percentage of a fund’s movements that can be explained by movements in its benchmark index. An R-squared value of 100 indicates that all of the fund’s movements can be explained by movements in the index.” In translation, R-squared helps investors check how similar a particular fund is to a specific index. For instance, if you already have an S&P 500 fund in your portfolio, you wouldn’t want to add another mutual fund with an R-squared of 0.99 because this indicates a 99% correlation with the S&P 500. The new potential fund would perform almost identically to the existing S&P 500 fund in your portfolio. That’s not diversification!
Alpha:
This is a measure that can give you an idea of how much value the fund manager adds to or subtracts from the mutual fund. Alpha gives expectations for returns that exceed (or fall short of) what beta would predict. Referring back to our beta example (above), if beta is 1.10 and the market rises by 10%, a fund with a positive alpha is expected to return more than 11% (the amount predicted by beta). You want to look for funds with positive alpha!
Sharpe Ratio:
Using the Sharpe ratio, the investor can get an expectation of how well the return of a particular mutual fund compensates the investor for the risk taken. Simply put, the higher the Sharpe ratio, the better. For example, receiving relatively high returns for taking on an average or below-average level of risk is desirable, and the Sharpe ratio can help provide calculated expectations for this potential outcome.
Total Expense Ratio:
Funds with lower costs are often the best, especially over the long term (e.g., 10 years or more) as expenses tend to be a drag on performance.
Tax Cost Ratio:
If you are investing in a taxable account, you should be cautious when investing in funds that generate income (e.g., dividends, capital gains distributions) that may be taxable. More taxes mean lower net returns for you as an investor.
Note: Except for the total expense ratio and tax cost ratio, the quantitative measures listed in this article are best used for researching actively managed funds, not index funds.
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Sources:
The Balance
Morningstar
Source: https://www.thebalancemoney.com/how-to-use-statistical-analysis-with-mutual-funds-2466457
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