Reference Materials
Mutual Fund Analysis
When investing in non-index mutual funds, investors make two critical assumptions: 1) that skillful managers exist, and 2) that they have the ability to recognize them. If an investor is not willing to make these two assumptions, they should invest in non-active funds like index funds or exchange traded funds (ETFs). Mutual fund analysis, both qualitative and quantitative, attempts to identify skillful active managers. Qualitative analysis looks at factors such as the background and experience of the manager and the mutual fund company. Here, we look only at the quantitative factors such as manager performance, style, style consistency, risk, risk-adjusted performance, etc.
What is the best way to analyze, and ultimately select, mutual funds?
Financial journalists are not equipped to analyze mutual funds. In most cases they are simply reporting the performance figures they received from the managers themselves or the marketing/public relations people. Mutual fund rating services are good data collectors but lack any real sophistication in fund analysis. These services are oriented toward the retail fund investor. Consequently sophisticated advisors, plan sponsors and consultants must perform their own mutual fund analysis.
The two biggest mistakes in quantitative mutual fund analysis are improper benchmarking and end point bias. How can you avoid these mistakes?
Benchmarking
The most common error made when measuring a manager’s performance is the selection of an improper benchmark. Morningstar’s star ratings, for example, are based on fund’s performance relative to a broad group of fund returns, as opposed to a more specific benchmark that reflects the manager's true style. Because of this, on February 28, 2000, at the very peak of the growth stock bubble, most of Morningstar’s five star funds were growth funds while there were no five star value funds. Two years later, after the value funds did well and the growth funds crashed, most of the five star funds were value funds.1 Due to the importance of proper benchmarking, we devote a special section to it (see Benchmarks).
End Point Bias
The other common mistake made in performance analysis is called “end point bias.” Most of the funds recommended by various financial publications are ones that recently performed well. When looking at cumulative statistics, recent performance above the benchmark creates the illusion that the fund has consistently outperformed. Cumulative statistics are calculated through the most recent time period. Annualized return for one, three, five, and seven years, for example, is often used to evaluate mutual funds. Notice that the most recent year is included in all of these periods. Due to the nature of these statistics, recent performance often “hides” past performance.
Here is an example. The September 15, 2003 Forbes magazine heralded the Mairs & Power Growth fund as one of the three best funds to own based on its long term record. In Figure 1 the long term annualized returns for this fund look quite good.
Because this fund outperformed its benchmark (the S&P 500 is a reasonable benchmark for this fund) for 2, 3, 5, 7, 10, 15, 20, and 25 year periods, one would think that the fund is a consistently good performer. Now look at Figure 2 below. The red and green shaded area at the bottom of the performance graph shows the cumulative return relative to the benchmark. If you had purchased this fund 25 years ago you would have spent all but the last couple of years below your benchmark. It has only been the very good performance in the last few years that give it the high annualized rates of return found in Figure 1. This is what we mean by an “end point bias.” We could also call it the broken clock syndrome (a broken clock will be right twice a day). Similarly, if a manager has been managing money for 25 years, even with no skill, there is likely to be several years of good performance. If your end point (the date on which your analysis ends) is particularly good, cumulative statistics may create the illusion of consistently good performance.

Would Forbes have recommended this fund three years earlier? We doubt it. Figure 3 shows us that through February 2000 the fund had under performed its benchmark by 842 percentage points.

Figure 4: Mutual Fund Analysis - Mairs & Power Growth Fund Returns for Specific Periods



Figure 7: Mutual Fund Analysis - Fidelity Low Priced Stock Fund Excess Return
