Investing is all about looking forward. Sure, your mutual fund might have gained 10% last year, but how is it going to do this year? How much money will you have at the end of the year? The Fundata Analytics team wanted to find out if there is a reliable trend that helps identify top-performing funds year to year. If so, we also wanted to find a way to capture and quantify that trend in a metric that would give investors, advisors, and money managers another tool to help select funds and allocate assets appropriately.
There are plenty of opinions on top-performing funds, but most of them are backed by historical data, and those that are forward looking are exactly that, opinions. So we started looking at the Fundata FundGrade® Rating as a purely quantitative metric with the potential of highlighting funds that are likely to outperform in the coming year. FundGrade is a risk-adjusted performance-based evaluation metric using a grading system. It assigns an A-Grade to the top 10% of funds based on three return-versus-risk ratios.
In particular we wanted to see if there was any indication that A-Grade funds, funds that have outperformed their peers in the past, would continue to outperform in the future. This led to the development of the FundGrade Transition Matrix.
The FundGrade Transition Matrix displays the probabilities associated with changing FundGrades. In other words, it shows the probability that an A-Grade at the beginning of the year will be an A-Grade at the beginning of the following year, or a B-Grade or a C-Grade, etc. The results are shown in the following table:
The matrix shows that 62.2% of A-Grade funds at the start of 2012 repeated as A-Grades at the start of 2013. This is an impressive result, showing the predictive strength of the FundGrade metric, especially when you consider a similar matrix based on 1-year return quartiles.
Just 33.2% of first-quartile performers in 2011 remained in the first quartile for 2012. This is just a slightly better number than you would expect if the year-to-year returns were completely independent (25%). It appears as though there is no consistency from one year to the next in terms of returns. Also interesting from this table is that at 25.2%, fourth-quartile funds in 2011 had a better chance of making the first quartile in 2012 than did the second- and third-quartile funds at 18.9% and 19.6% respectively.
One explanation for this is that the FundGrade calculation uses multiple years of data for each fund, while the quartile matrix is looks at year-to-year data. So we ran the numbers again, this time looking at the 3-year compound return quartiles up to the end of 2011 and how that translated into 2012 performance. The results are roughly the same:
In fact the chance of a first-quartile fund based on 3-year compound return repeating as a first-quartile in 2012 falls to 31.2%. Again it appears as though there is no consistency in terms of returns, and there is a better chance that the first-quartile performers end up in the fourth quartile than the third quartile a year later.
These numbers reinforce the caveat that “past performance is not an indicator of future performance,” especially when you only consider the returns. Part of the reason that quartile rankings do not provide any indication of performance consistency year to year is that funds with consistently high volatility will almost always have good years followed by bad years and vice versa.
The FundGrade performance measure uses three risk-adjusted ratios and considers every time period from 2 to 10 years. As a result, the FundGrade tool identifies the most consistent funds on a return-versus-risk basis. This translates to better expected performance in years to come:
This table shows the average 2012 returns and standard deviations, grouped by FundGrade level achieved in 2011. Again, the results show that A-Grade funds can be expected to perform at a higher level the next year, while maintaining the lower volatility.
Fundata’s Analytics team will be producing the FundGrade Transition Matrix on both a monthly and an annual basis. FundGrades are updated every month, and FundGrade A-Grade funds are published monthly on the FundGrade "A" List.
Reid Baker is Manager, Analytics and Data, at Fundata Canada Inc., a leading source for investment fund information, and is Chairman of the Canadian Investment Funds Standards Committee.
Notes and Disclaimers
© 2013 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.