Evaluating large US‐based equity mutual funds using risk‐adjusted performance measures

Abstract

PurposeThis paper seeks to evaluate the risk‐adjusted performance of the largest US‐based equity mutual funds using rigorous analysis grounded in modern portfolio theory and present the results in a manner which is comprehensible to a lay investor.Design/methodology/approachThis study evaluates the performance of the 20 largest US‐based mutual funds using risk‐adjusted returns during 1995‐2004. In particular, a relatively new risk‐adjusted performance measure by Modigliani and Modigliani is used to evaluate these equity funds. This study also utilizes a variation of the Sortino Ratio to account for downside risk.FindingsThe results show that the funds with the highest returns may lose their attractiveness once the degree of risk had been factored into the analysis. Conversely, some funds may look very attractive once their low risk is factored into their performance.Research limitations/implicationsFuture researchers may want to investigate the effects of factors, such as fund manager, compensation, service fees, corporate governance metrics, and overweighting in risky industries on the performance of mutual funds.Practical implicationsThe empirical evidence presented in this study can be used as input in decision making by investors who are exploring the possibility of participating in the stock market via large mutual funds, but are not sure of what selection criteria to employ.Originality/valueThe paper is one of the first studies that apply the new M2 measure to evaluate the performance of mutual funds. Various other performance metrics are also utilized including the Sharpe, Sortino, Treynor measures and Jensen's α.