Risk-Adjusted Performance of Mutual Funds

T he number of mutual funds has grown dramatically in recent years. The Financial Research Corporation data base, the source of data for this article, lists 7,734 distinct mutual fund portfolios. Mutual funds are now the preferred way for individual investors and many institutions to participate in the capital markets, and their popularity has increased demand for evaluations of fund performance. Business Week, Barron's, Forbes, Money, and many other business publications rank mutual funds according to their performance. Information services, such as Morningstar and Lipper Analytical Services, exist specifically for this purpose. There is no general agreement, however, about how best to measure and compare fund performance and on what information funds should disclose to investors. The two major issues that need to be addressed in any performance ranking are how to choose an appropriate benchmark for comparison and how to adjust a fund's return for risk. In March 1995, the Securities and Exchange Commission (SEC) issued a Request for Comments on " Improving Descriptions of Risk by Mutual Funds and Other Investment Companies. " The request generated a lot of interest, with 3,600 comment letters from investors. However, no consensus has emerged and the SEC has declined for now to mandate a specific risk measure. Risk and performance measurement is an active area for academic research and continues to be of vital interest to investors who need to make informed decisions and to mutual fund managers whose compensation is tied to fund performance. This article describes a number of performance measures. Their common feature is that they all measure funds' returns relative to risk. However, they differ in how they define and measure risk and, consequently, in how they define risk-adjusted performance. The article also compares rankings of a large sample of funds using two popular measures. It finds a surprisingly good agreement between the two measures for both stock and bond funds during the three-year period between 1995 and 1997.