TAKING STOCK: Understanding mutual fund investment terms

Dear Mr. Berko:

Last week, a reader from Texas asked you to explain mutual fund investment concepts, including standard deviation and Sharpe ratio. You told the reader how to select a mutual fund, but you did not explain those terms. I own eight mutual funds, in my two individual retirement accounts and two in a joint account that is worth a total of $144,000. I think it would be good for me to understand what those terms mean. I will be investing $20,000 in two more mutual funds, and this might help me pick the right funds.

JG, Portland, Ore.

Dear JG:

Well, raise my rent! OK, the following explanations should clearly define last week's fancy-schmancy concepts, which some money managers pretend to use in selecting mutual funds for their managed accounts.

Standard deviation measures how much a fund's annual return (in one specific year) may be expected to vary from its average annual return (the average of many annual returns) during any specific year. It is said that a fund's annual return is expected to fall within 1 standard deviation of its average annual return two-thirds of the time. For example, if Holy Mackerel Fund has an average annual return of 13 percent and an SD of 7, it can be expected to have an annual return in any specific year that is between the range of 6 and 20 percent two-thirds of the time. And one-third of the time, the performance of HMF is expected to fall outside (above or below) the 6 percent and 20 percent perimeters.

Beta measures a fund's sensitivity to changes in its investment benchmark in its sector, such as banking, health care, retail or biotech. A beta of 1 tells us that if Holy Mackerel Fund's benchmark moves 12 percent during the year, HMF also will move 12 percent. A beta of 1.5 indicates that HMF will move 1.5 times the benchmark (18 percent), and a beta of 0.5 suggests that HMF will move half as much as the benchmark.

R-squared measures the degree to which a fund's price change is related to an external benchmark. So if HMF has an R2 of 79 relative to the Standard & Poor's 500 index, then one can assume that 79 percent of HMF's historical price behavior can be attributed to the S&P 500 index.

Wall Street has determined that there are 88 (maybe more) individual investment styles. I won't list them all. It suffices to say some styles are midcap growth, midcap balance, midcap value, midcap blend, large-cap growth, balance, blend, global, single country and international. Every fund is classified into one of these styles based upon its long-term investment history.

So style drift measures the tendency of a fund's management to deviate from its specific investment style over a period of time. And alpha measures a fund's actual results and compares it with the results one could expect from a statistically average fund in the same category with the same beta. If HMF returns more than its beta predicts, then it has a positive alpha, and if it returns less, then it has a negative alpha.

The Sharpe ratio is a ridiculously nonsensical number concocted by two dotty Nobel laureate economists who got bored counting sheep. If HMF produces a 25 percent return this year with an SD of 10 while the 60-day Treasury bill rate returns 0.25 percent, its Sharpe ratio equals 2.475. The calculation looks like this: 25 percent of the annual return minus the 0.25 percent T-bill rate divided by an SD of 10 produces a Sharpe ratio of 2.475. The higher the Sharpe ratio the better the fund's returns have been relative to the amount of investment risk it takes. How exciting!

There are probably a few dozen more nebulous and equally useless concepts claiming to predict superior investment performance. They're all tommyrot and equally as accurate as reading ripped entrails or tossing chicken bones. Nothing works in a down market. And in an up market like the one we're enjoying, tossing darts at a selected list of funds would give you better results.


Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775 or e-mail him at mjberko@yahoo.com. Visit Creators Syndicate website at www.creators.com.

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Published: Mon, Jun 24, 2013