Share Market

All mutual funds have a stated investment mandate that specifies whether the fund will invest in large companies or small companies, and whether those companies exhibit growth or value characteristics. It is assumed that the mutual fund manager will adhere to the stated investment objective. When investing in mutual funds, investors make two critical assumptions: 1) that skilful managers exist, and 2) that they have the ability to recognize them.

By analyzing the sector weights of a fund and the fund manager’s attributions to performance, an investor can better understand the historical performance of the fund and how it should be used within a diversified portfolio of other funds.

Sometimes fund managers will gravitate toward certain sectors either because they have deeper experience within those sectors, or the characteristics they look for in companies force them into certain industries. A reliance on a particular sector may leave a manager with limited possibilities if they have not broadened their investment net. The investor must compare the fund to its relevant indexes to determine where the fund manager increased or decreased his allocation to specific sectors relative to the index. This analysis will shed light on the manager’s over/underexposure to specific indexes (relative to the index) in order to gain additional insight on the fund manager’s tendencies or performance drivers.

An investor can also break down the portfolio into market cap groupings and determine whether the fund manager is particularly skilled at picking companies with certain size characteristics. In order to determine whether a fund manager is actually adding any value to performance based on asset allocation or stock picking, an investor needs to complete an attribution analysis that determines a fund’s performance driven by asset allocation versus performance driven by stock selection. Attribution analysis, for example, can reveal that a manager has placed incorrect bets on sectors but has picked the best stocks within each sector.

Statistical measures like Tracking error, which is which is the volatility (standard deviation) of excess return is also used to analyze risk. All things equal, the less volatile the excess returns the greater the chance the manager is skilful rather than lucky. Tracking error is used to calculate a risk-adjusted measure of performance called the “information ratio.” The information ratio is the annualized excess return divided by the tracking error.