Mutual Fund Ratings: What is the Risk in Risk-Adjusted Fund Returns?

Several ̄rms use historical returns to rate or rank the performance of mutual funds, for the bene ̄t of individual investors desiring to invest in one or more of them. Because the past will not exactly repeat itself, such ratings re°ect di®erent notions of \risk" faced by investors. This paper describes and analyzes the performance measures employed by some advisory ̄rms. Approximations are derived to facilitate understanding and comparison of these measures. Simple modi ̄cations are proposed to transform these measures into a fund performance measure that is directly related to the fund's probability of outperforming a user-selected benchmark's cumulative return. Perhaps the most important problem plaguing all these measures is the di±culty of accurately estimating expected returns from historical averages, even when a high number of years is used. A proposal to use ̄ltering to alleviate this di±culty is explained and discussed.