Analyzing Mutual Fund Performance (2024)

How Do You Analyze a Mutual Fund's Performance?

You analyze mutual funds by weighting the stocks in the fund by sector and then determining management's contribution. You'll need understand some of the fund's inner workings before diving into an analysis, then work through several steps to reach the results that indicate management's contribution to a fund.

Understanding Mutual Fund Portfolio Analysis

To understand a mutual fund, you'll need to learn how it is supposed to operate. This information is usually in its prospectus and describes its mandates. In this document, you'll also find the sectors it invests in and how much of the portfolio is dedicated to each. You may or may not be able to find information on how a manager picks stocks for the fund.

Investment Mandates

All mutual funds have a stated investment mandate specifying whether the fund will invest in large 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. It's a good start to understand the fund's specific investment mandate, but there is more to fund performance that can only be revealed by digging a bit deeper into the fund's portfolio over time.

Sector Weights

Sometimes, fund managers will gravitate towardcertain sectors either because they have deeper experience within them 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.

To determine a fund's sector weight, it helps to use analytical software or sources like Yahoo or MSN. Regardless of how the information is obtained, you must compare the fund to its relevant indexes to determine where the fund manager increased or decreased their 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 into the fund manager's tendencies or performance drivers.

The analysis can be as simple as listing the fund and relevant indexes side by side with a breakdown by sector. For example, for a large-cap manager, the simplest way to determine sector reliance is to place the fund's sector breakdown next to both the and the . Both indexes exhibit unique sector breakdowns because certain sectors routinely fall into the value category while others fall into the growth category. Technology, known more as a growth sector, will have a higher weight in the S&P/Citigroup Pure Growth Index than in the S&P 500/Citigroup Pure Value Index. Industrials, on the other hand, known as a value sector, will have a higher weight in the S&P 500/Citigroup Pure Value Index than in the S&P 500/Citigroup Pure Growth Index. A comparison of the fund relative to the sector breakdown of these two indexes will indicate whether the fund is in line with its stated mandate and reveal any over- or under-allocations to a specific sector.

The key to this analysis is to perform it on current and historical data to identify any tendencies the fund manager may have.

Attribution Analysis

There are fund managers who claim to have a top-down approach and others that claim to have a bottom-up approach to stock-picking. Top-down indicates that a fund manager evaluates the economic environment to identify global trends, and then determines which regions or sectors will benefit from these trends. The fund manager will then look for specific companies within those regions or sectors that are attractive.

A bottom-up approach, on the other hand, mostly ignores macroeconomic factors. A manager that employs a bottom-up methodology will filter the entire universe of companies based on certain criteria, such as valuation, earnings, size, growth or a variety of combinations of these types of factors. They then perform rigorous due diligence on the companies that pass through each phase of the filtering process.

In order to determine whether a fund manager is actually adding any value to performance based on asset allocation or stock picking, you need to complete an attribution analysis that determines a fund's performance driven by asset allocation vs. performance driven by stock selection. Attribution analysis can reveal that a manager has placed incorrect bets on sectors but has picked the best stocks within each sector. Using this example, this manager should have a bottom-up approach. If the manager's mandate describes a top-down methodology, this might be a cause for concern because you've discovered that the fund manager has improperly allocated the portfolio (using a top-down approach).

Example of a Mutual Fund Portfolio Analysis

Here is a five-sector portfolio as an example: In the tables below, you see a comparison of a mutual fund portfolio with its relevant benchmark. The table identifies how much of the portfolio's performance was attributable to asset allocation (sector weights) vs. how much was attributable to superior stock picking.

In the first chart, we see the sector weights for the fund's portfolio for each of the five sectors. The second column in that chart shows the return of each sector within that portfolio, and the third column calculates the contribution of each sector to the fund's total return (weight multiplied by return). Follow these steps:

1. Determine the sector weights for both the fund and the index (30%, 20%, and so on). This is the percent of the portfolio the sector makes up.
2. Calculate the contribution of each sector for the fund by multiplying the sector weight by the sector return. Repeat for the index.
3. Calculate the rate of return for the fund by adding the sector contributions. Repeat for the index. In this case, the fund had a return for the period of 4.38%. The second chart shows the same calculations for the relevant benchmark. We could see that the total return for the benchmark was 3.555% and that the fund outperformed the benchmark by 0.83%.
4. Calculate the overweight amount by subtracting the index (benchmark) weight for each sector from the fund (portfolio) weight for each sector.
5. Calculate performance by subtracting the index return for each sector from the fund return for each sector. Notice that the fund had a 30% weight to Sector 1 while the benchmark only had a 20% weight. As such, the fund manager over-allocated to this sector, assuming it would outperform. We can see from the return of 4.2% for Sector 1 within the fund was 2% less than the return for the same sector within the benchmark. Now, this might get a bit tricky: The fund manager made the correct choice of allocating to Sector 1 as the sector for the benchmark had a return of 6.2%, the highest of all five sectors. However, the security selection within the sector was not very good, and, therefore, the fund only had a 4.2% return.
6. Calculate the selection attribution by multiplying the benchmark weight with the difference in performance.
7. Calculate the allocation attribution by multiplying the index return for each sector by the overweight amount.
8. Calculate the interaction by multiplying the overweight column by the performance column.
9. Combine the Selection, Allocation, and Interaction totals to get the Active Management Effect, 0.88.
10. Add the Interaction column to arrive at a total of -0.055. This will be entered into the Error row.
11. Add the Error and Active Management Effect to arrive at Overperformance, 0.825.

The third chart shows the calculation of both allocation and security selection contributions. In this example, the manager's contribution to performance for overweighting Sector 1 was 0.62%, but the manager wasn't as successful in selecting securities, which resulted in a contribution of -0.4%.

The last table shows the active management effect of positive 0.88% minus the unexplained portion of -0.055, resulting in an active management contribution of 0.825%.

As you can see, this information is very useful for determining whether a manager is driving performance through asset allocation (top-down) or security selection (bottom-up) analysis. The results of this analysis should be compared to the fund's stated mandate and the fund manager's process.

The Bottom Line

There are many other factors to consider when analyzing a mutual fund's portfolio. By analyzing the sector weights of a fund and the fund manager's attributions to performance, you can better understand the fund's historical performance and how it should be used within a diversified portfolio of other funds. You 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.

Whichever factor or characteristic you want to analyze, the results can provide valuable insight into a manager's skill and further enhance the investor's portfolio construction process. Ideally, you would want a mix of good allocators and good stock pickers, as well as fund managers with different levels of expertise in certain sectors. This type of analysis, although time-consuming, can provide the information required to properly analyze a portfolio.