Fund Scores Fine-Tuned

10/17/2016


Our fund scores gauge the appeal of nearly 5,650 mutual funds and exchange-traded funds (ETFs) with a single number. That number does an excellent job.

In a back-test since 2009 covering 72 rolling 12-month periods, the top one-fifth of funds in a category outperformed the average fund by an average of 0.9%.

While it might seem unwise to mess with success, a few tweaks should make our scores even better. Recently, we re-examined the factors that go into the rankings. Our research showed:

Expense ratios are strong predictors of fund performance. That makes sense, as every dollar paid in management fees is a dollar less earned. The top 20% of funds based on expense ratio outperformed the average fund in their category by roughly 0.6%. The expense ratio represents 30% of the fund score — the largest weighting.

Risk-adjusted performance metrics work well. Our ranks incorporate such factors as Sharpe ratio, which compares a fund's returns above a risk-free rate to its volatility. We increased the weight for the information ratio — the most effective metric. It compares a fund's volatility and performance to a benchmark. Since 2009, the top 20% of funds based on information ratio outperformed by 0.9%. The ratio worked in 86% of 12-month periods.

Long-term performance works better than short-term returns. Our system requires that a fund have a five-year history, which helps evaluate performance over various market conditions. We trimmed the weight assigned to three-month returns but increased weights for both three- and five-year returns.

Tax efficiency is a middling predictor of performance. The tax efficiency variable, which divides after-tax returns by pretax performance, worked only one-third of the time for the top one-fifth of funds. Interestingly, the metric worked better for the bottom 20%. We are dropping the factor.

To be sure, even minor tweaks won't make fund scores bulletproof. The scores, calculated monthly, are driven by historical data and impacted by survivorship bias, as small or underperforming funds may drop out of our research universe. Still, the scores can help isolate standout funds across 116 categories. Rankings are available online in the Subscriber Area at www.DowTheory.com/Go/Funds. Among our 20 recommended funds, 18 earn scores above 80.

Fund portfolio update

Through Oct. 11, the Growth Portfolio has gained 5.4% in 2016, versus 6.6% for its passive benchmark portfolio. The Conservative Portfolio is up 5.2%, compared to a 5.1% gain for its benchmark. In the Oct. 3 newsletter, Vanguard Selected Value ($27; VASVX) was dropped from both portfolios and replaced with Vanguard Mid-Cap Value Index ($36; VMVIX), which earns a fund score of 94. The fund, up 7.8% this year, has a modest 0.20% expense ratio.

HIGH SCORERS OUTPERFORM
Our fund scores rank nearly 5,650 funds based on total returns, expense ratios, and risk-adjusted performance. Listed below are results of a back-test since 2009 for 27 popular categories using our fund scores. For example, the top one-fifth of large-cap blend funds outperformed the average fund in their category by 0.5%.
Average 12-Month Return Of Top
------ Scorers, Relative To Category ------
Category
Average
(%)
Winning
%
Standard
Deviation
(%)
U.S. stock funds
Large-cap blend
0.5
72
0.8
Large-cap growth
1.3
90
1.1
Large-cap value
0.4
72
1.2
Midcap blend
0.6
71
1.1
Midcap growth
0.9
79
1.1
Midcap value
0.7
75
1.0
Small-cap blend
0.7
75
1.0
Small-cap growth
0.6
75
0.9
Small-cap value
0.6
69
1.3
Foreign stock funds
Large-cap blend
1.1
92
0.9
Large-cap growth
(0.3)
42
1.2
Large-cap value
0.6
69
1.3
Emerging markets
1.9
83
1.9
World
(0.1)
43
1.6
Bond funds
High-yield
0.1
60
0.6
Intermediate-term
0.5
86
0.4
Intermediate-term government
0.4
76
0.6
Intermediate-term muncipal
0.5
85
0.5
Short-term corporate
0.5
93
0.4
Short-term government
0.4
74
0.5
World
0.8
60
2.0
Balance and sector funds
Balanced — bond bias
1.1
92
0.9
Balanced — stock bias
1.0
85
0.7
Financial
0.1
54
2.6
Health care
2.3
65
5.4
Real estate
0.4
64
1.3
Technology
1.5
72
2.2

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