Despite decades of statements to the contrary, it turns out that past performance actually is a pretty good indicator of future mutual fund returns — provided that the performance is adjusted for risk.
By measuring the volatility of mutual funds' average daily returns, some researchers think that they have discovered a risk measurement tool that can predictably identify funds destined to outperform the S&P 500.
“You have to think of [lower] volatility as the tendency of a fund to behave consistently,” said Anthony DuBon, manager of strategy and operations at Investment Risk Management Systems Inc., the developer of FundReveal, a web-based program that analyzes risk-adjusted returns.
When FundReveal measures the pattern of daily volatility against average daily returns for a given period, those measures can be compared with a benchmark such as the S&P 500 to illustrate relative risk and return characteristics.
Applied to any size universe, the same formula will identify those funds that have the greatest tendency to provide the best returns with the least amount of risk. This works, according to the researchers, because low risk is predictable and doesn't necessarily mean low returns.
“It's not rocket science; it's just a fact-based analysis that shows funds are not necessarily efficient,” said Ani Chitaley, the company's president.
He spent nearly three years crunching data that led to the development of FundReveal.
The objective of the program is to identify funds that offer lower volatility and higher returns than the index. Such funds appear in the upper-left quadrant of a scatter diagram.
“There is no guarantee, but statistically, we have proven that if you select funds that were in the [upper-left quadrant] the previous year, the probability is that they will beat the S&P the following year,” Mr. Chitaley said.
BACK-TESTING
According to the FundReveal program, a portfolio that invested solely in funds that wound up in the prior year's upper-left quadrant would have produced an average annual return of 7% each year over a 10-year period through 2010.
That compares with an average annual loss of 1% by the S&P 500 over the same period.
FundReveal has not yet calculated fund data for 2011, but those upper-left-quadrant funds outperformed the index six times, tied it twice and slightly lagged the index twice over the 10-year study period.
Of course, not everyone is ready to scrap the standard “past performance” boilerplate just yet.
“[FundReveal] sounds almost like a momentum trading strategy to me,” said Russel Kinnel, director of research at Morningstar Inc.
GRADING SYSTEMS
Morningstar, which recently started rolling out forward-looking “analyst ratings” for funds, has long de-scribed its popular star ratings — which are based on performance over three-, five- and 10-year periods — as “grades for achievement.”
Mr. Kinnel doesn't believe that FundReveal's method of analyzing the previous 12 months as an indicator of the next 12 months is enough to “suggest a manager has added value over the long term.”
Bruce Fleet is less critical.
“It's not the Holy Grail, but it does shoot a hole in the theory that you need to add risk in order to add return,” said Mr. Fleet, president of Fleet Capital Management LLC, a fee-only advisory firm.
“We can't manage returns, but we can manage risk because risk is quantifiable and measurable,” he said. “If we're both getting the same returns for 10 years but I'm taking on 30% less risk, I'll be in better shape because less risk means I'll lose less.”
Mr. Fleet answers criticism of his methodology by saying that Fund- Reveal is focused on how a fund is likely to perform in the future based on the consistency of risk-adjusted recent returns.
“I happen to also like Morningstar because they have the star ratings and the analyst's picks, and I'll put those funds into something like FundReveal,” he said. “I'm interested in the investment-making capability of a portfolio manager, and I know if a fund is in the [upper-left] quadrant, there is a degree of consistency of producing a low-risk rate of return.”
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected]
