Thursday, January 20, 2005

Mutual Fun(ds)

If you like investment data these lists are always fun to review. BusinessWeek published their annual Mutual fund review and the "A" list is linked. I believe a thorough quantitative review is the first step in isolating a universe of investment funds that one would consider for further review. The issue with the rating process is the informational "cost" of oversimplification. Proprietary fund ranking processes, and everyone has got one, tend to focus on historical returns and risk by category. The ranking formula's will weight each factor based on the sponsor's perception of the importance of each factor. For instance, most formulas will weight a three year historical return more heavily than a five year return. Logic suggests more recent returns are more relevant than those further back in time. Unfortunately, while this makes common sense, there is little to no evidence suggesting a higher correlation between prior 3 year results and future results. On the other hand, one would like to think that using some rational and disciplined basis for investment evaluation, even if oversimplified, might add value over randon selection. I think this may be true. Given the limitations implicit in these ranking models, they may be useful in stratifying an investment population into two groups; those with possible merit vs those without.

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