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Exploring Mutual Funds – Evaluating Performance

Ray Calleja

An article written by Ray Calleja: Head – Private Clients, MeDirect

As we come to the end of our regular articles about Mutual Funds, I felt it is opportune to go over the important topic of how to evaluate mutual funds’ performance. It is of utmost importance that potential or existing investors understand the information that they will encounter when reviewing performance reports, especially Morningstar reports, which are available on the MeDirect website for all mutual funds on our universe. Knowing how to decipher these reports or factsheets will help you better understand the information contained therein to be able to evaluate performance and eventually select the right mutual fund for your objective and risk tolerance.

Morningstar Ratings

We discussed in detail the Morningstar Ratings in the article titled Measuring Risk and Return. This rating system started back in 1985 and continued to evolve since then, where the rating took into account new factors including the way the risk-adjusted return is measured. The two main components of this system include:

Category Rankings – where mutual funds are ranked within categories such as large value, large blend, speciality funds etc. Funds are ranked while comparing them to peers, so an investor gets a better sense of relative performance.

Risk Adjustments – mutual funds are rated for their risk with a bigger emphasis on downward risk, where the focus is mainly on avoiding a negative outcome for the investor. Morningstar uses a risk rating that is based on what is termed the ‘utility theory’. This assumes that investors are more concerned about negative outcomes than they are with unusually high returns. Funds which perform moderately well on a consistent basis are rated higher than those which perform very well one year but then poorly the next year.

As many of you know, the highest possible rating by Morningstar is a mutual fund with a five-star rating. The evaluation is based on assessing performance over three, five and ten years. Whenever possible Morningstar places more emphasis on a fund’s longer-term performance. Thus if, for example, a fund has been in existence for ten years or more the weighting of the rating would be such that 50% of the rating is attributed to the 10-year rating, 30% to the 5-year rating and 20% to the 3-year rating. Morningstar distributes stars based on relative performance, too. So, in any given category 10% of the mutual funds are given a 5-star rating; 22.5% of funds are given a 4-star rating; 35% of funds are given a 3-star rating; 22.5% are given a 2-star rating and 10% a 1-star rating. This means that a fund, which is given a 5-star rating has out-performed 90% of its peers competing in the same category of mutual funds. Morningstar breaks portfolios into peer groups based on their holdings. Portfolios are placed in a given category based on their average holdings’ statistics over the past three years.


In our previous article we discussed the different types of returns that are presented to investors for mutual funds’ performance. Historical returns are usually stated in absolute and also relative terms. A chart of this information in a factsheet will usually show the actual performance of the fund over time, in addition to comparing that performance to its peers and also to its benchmark or index. See example below.

article image - Evaluating Performance

Thus, in the example above the performance of the fund in 2018 (the red line) performed 3.91% better than its index and 6.20% better than its category whereas its performance up to 20 Aug 2020 was 8.77% worse off than its index and 2.37% worse than funds in its category, despite achieving a 5.93% total return. In this example, the category benchmark is the MSCI ACWI Growth NR USD and the category is Global Large-Cap Growth Equity. In this way, the investor is able to visualise and compare the relative performance of the mutual fund against the market and its peers.

There is also a percentile rank in category. This value reveals how well that fund did relative to its competitors. For example, in the same example above, the fund under review was ranked 50th out of 100 as at 20 Aug 2020; 54th out 100 in 2018; 4th out of 100 in 2018 and 3rd out of 100 in 2017. The percentile rank is the fund’s total-return relative to all funds that have the same Morningstar category. The highest (or most favourable) percentile rank is 1 and the lowest (or least favourable) percentile rank is 100. Percentile ranks within Categories are most useful in those categories that have a large number of funds. For small universes, funds will be ranked at the highest percentage possible. To take another example, if there are 220 large value funds and a specific fund is ranked # 110 for a time period (for example, one year), its category % rank will be 50 (110/220=50%).

Volatility Measures

Apart from returns, we also discussed in the earlier articles in this series, the issue of risk and volatility (you can find these articles here and here). Volatility measures for mutual funds provide investors with a good feel for the stability of the fund from year to year. We had discussed in some details the following risk measures:

Standard Deviation

This is a measure of the range in the performance of the mutual fund. The higher the fund’s standard deviation, the greater is the risk of volatility.  For example, when comparing two mutual funds with the same average return, the fund with the higher standard deviation had greater fluctuations in return from year to year.

Average Return

This is the mean, or average, return for a mutual fund over the time period stated.  Averages are usually stated in 3-, 5-, and 10-year lengths and are called annualised returns.

R Squared

R squared measures the correlation between the returns of a fund and its benchmark and is usually stated as percentages or values from 1 to 100%. R-squared versus a standard market measure, such as the S&P 500 Index, tells the investor how much of the fund’s movement can be explained by the movement of the market.  If a fund’s R-squared value is 100%, then the fund moved up and down exactly like its index, e.g. the S&P 500.


A mutual fund’s beta measures the systematic risk that is based on the co-variance of a fund’s return with the return of the benchmark. A low beta does not imply that a fund has a low level of volatility, but it does suggest that a fund’s index-related risk is low. Beta measures that are higher than 1.00 will indicate higher highs but lower lows.

For example, if a mutual fund has a beta of 1.1, the fund has been 10% more volatile and has performed 10% better than its index, say the S&P 500 Index in a bull (rising) market.  This also means the fund may be expected to under-perform the S&P 500 Index by 10% in a bear (falling) market.


The alpha of a mutual fund measures how well a fund performed relative to its expected performance. It measures the value added or subtracted by a fund’s management team. It represents the difference between a fund’s actual returns and its expected performance, given its level of risk as measured by beta. The baseline for alpha in mutual funds is 0. A figure of 0 is indicative of a fund manager’s performance to be exactly in line with the benchmark index. Alpha higher than 0 reflects the fund manager’s achievement of outperforming the benchmark index.

Sharpe Ratio

A Sharpe ratio is a risk-adjusted measure that was developed by Nobel prize-winner William Sharpe.  The Sharpe ratio is a measure of the excess returns for each unit of risk.  The ratio is normally calculated using performance over the previous 36 months.  The Sharpe ratio tells the investor how much excess return (relative to a risk-free investment – usually the Treasury Bills rate is used) the fund provides for each unit of risk. It is calculated by dividing a fund’s excess return by the standard deviation.

For example, if you are comparing a mutual fund to its peer category, and the fund’s Sharpe ratio is 0.50, while its peer category is 0.30, it means that one unit of risk returned 0.50 in excess returns for the fund, while the peer group only achieved 0.30 in excess returns.  Therefore, the risk-adjusted reward for this fund is higher than its peer group.

Although past performance is never a guarantee of what might happen in the future, it is a useful way of assessing how well or badly a fund has performed in comparison to its stated objectives, to its benchmark and also to its peer group. You need to measure performance over various periods, say 3 months, 6 months, one year, two years, three years and even five and ten years, if available. Funds which consistently appear in the top or thereabouts, in each of these time horizons, naturally deserve to catch your attention.

The above is for informative purposes only and should not be construed as an offer to sell or solicitation of an offer to subscribe for or purchase any investment. The information provided is subject to change without notice and does not constitute investment advice. MeDirect Bank (Malta) plc has based this document on information obtained from sources it believes to be reliable but which have not been independently verified and therefore does not provide any guarantees, representations or warranties.

MeDirect Bank (Malta) plc, company registration number C34125, is licensed by the Malta Financial Services Authority under the Banking Act (Cap. 371) and the Investment Services Act (Cap. 370).

The financial instruments discussed may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in any of the products discussed you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

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