When I first started providing a rating on mutual funds back in 2002, I developed a formula that considered a number of key performance and risk metrics. It looked at absolute return, relative return, volatility and relative volatility. It also took into account the length of track record of a fund when determining the rating for a fund.
It seemed to work very well over the years, but its biggest drawback was that it was complicated to explain. Whenever an advisor or investor would ask about my rating system, I could never explain how I arrived at my ratings in a clear, concise way.
Another challenge would often arise when someone would ask why two funds with rather similar returns would have differing ratings. With the formula approach, there was no quick way to look at the two funds to find out why the difference, leading to having to deconstruct the factors and look at each on its own to find the discrepancy.
After having gone through that exercise a few times in the past year, I thought it might be better to create a rating system that simply scored the various factors under consideration, weighted them based on importance and determined a rating based on the final score.
So that’s what I did. I looked at the key factors my current formula considered, then looked for any gaps and arrived at six key metrics that are now rated and scored in my new process. Each factor is give a score between one and five. The scores are then averaged, with a final grade ranging from A to F being assigned. Funds rated an A are the most attractive, while those receiving an F are less attractive. I am using a grading system very much like in school, with those receiving less than 50% are rated an F, those scoring more than 80% are an A, and the B’s, C’s, and D’s distributed accordingly.
The metrics I’m following are:
- Alpha – This is the excess return that a manager has been able to generate. The higher the Alpha, the higher the score.
- Sharpe Ratio – This is a measure of risk adjusted performance. It measures how much return an investment has delivered for each unit of risk assumed. The higher the Sharpe Ratio, the more return the investment has delivered for each unit of risk, and the higher the score a fund receives in my ratings model.
- Standard Deviation – this is a measure of volatility or risk. It measures the fluctuation that an investment has exhibited. The higher the standard deviation, the more fluctuation the fund has shown, so the lower the score it receives in my new ratings model
- Information Ratio – is a measure of how consistently a manager has outperformed its benchmark. It is basically the Sharpe Ratio of the monthly excess returns. Like with the Sharpe Ratio, the higher the better.
- Batting Average – this is another measure of how consistently the fund has outperformed. While the information ratio will factor in the level of outperformance, batting average is just a measure of how frequently. It’s like the win/loss percentage in baseball. A batting average of 500 means it has outperformed as often as it has underperformed. I like funds that win more than they lose. The higher the batting average, the better the score.
- R-Squared – finally, I like to look at the R-Squared of an investment. This is a statistical measure that shows how much of the return of an investment are the result of the benchmark. The higher the R-Square, the more the fund behaves like the benchmark. And as we know, if you want to beat the benchmark, you can’t be the benchmark, so my model favours those funds that have a lower R-Squared.
While these six factors are the ones I am starting with when the new ratings system goes live in the next few days, this new scoring system allows me the flexibility to bring additional metrics into the mix as they become available. For example, I am currently testing what effect bringing Downside Deviation into the process would have on improving the ratings results. Other metrics I hope to be able to incorporate in the future include upside and downside capture ratios and manager tenure.
My hope is that the increased transparency will make it easier to understand why funds are rated as they are, helping to reduce the amount of guesswork required. Watch for the new ratings with the December 31 Investment Fund Ranking Report, due to be released on January 15.
If you have any questions, please do not hesitate to contact me at info@paterson-associates.ca