The only way to tell if a mutual fund is well managed is to benchmark its performance against the performance of similar mutual funds in the same time frame and against the return achieved by the index or financial asset in which it specializes. Similar mutual funds for this matter are funds invested in the same financial assets whether it’s bonds, stocks or any other financial asset such as derivatives.
If we wish to determine if a certain mutual funds which invests in NASDAQ stocks is well managed we should first and foremost compare it to other mutual funds invested in NASDAQ stocks.
When trying to determine if a mutual fund is well managed we should ask the following questions:
Did the fund beat the market?
Mutual funds charge management fees. As a result we expect them to beat the return achieved by the specific index in which the fund specializes. Otherwise we should invest in the index directly by ETF’s for example.
What is the relation between market return (and other mutual funds) and the fund’s return on investment?
Some funds may generate returns of 3%-5%. The return itself is insignificant when trying to decide if the fund is well managed. It only has meaning when compared to the market return (or the return of other mutual funds). If the specific index this fund specializes in has generated a 1% return then the fund is probably well managed.
How much risk did the fund’s manager take in order to generate a certain return on investment?
Say a certain mutual fund has generated a high return on investment compared to other mutual funds in the same category. This is still not enough to determine it is well managed. We should look in to the risk we took by investing in that mutual fund. A well known rule of investment is the direct link between risk and return. A mutual fund might generate higher returns by exposing us to higher risks which we are not necessarily willing to take.
Is the performance of the mutual fund, risk and return wise, consistent?
Even a broken clock shows the right time twice a day. In order to determine if a mutual fund is well managed we should look for consistently high performance over time.
There are two more common indices used in determining how well mutual funds are managed. These indices are:
Sharpe’s Index – Used to determine the ratio of return to risk (measured in variability) this index is basically the return on investment of the fund minus the market’s return divided by the standard deviation of the portfolio. The higher the result the better More return per unit of risk.
Jensen’s performance measure – This index measures the excess return of a portfolio according to the CAPM model. This measure is less common.
To conclude, when trying to determine if a mutual fund is well managed we should look for:
1) High consistent performance over time compared to the market and other mutual funds
2) High return for unit of risk (measured by Sharpe’s Index)