Performance of Portfolios Based on the Expected Utility-Entropy Fund Rating Approach.

Daniel Chiew,Judy Qiu,Chenxiao Shi,Jiping Yang,Sirimon Treepongkaruna

doi:10.3390/e23040481

Abstract

Yang and Qiu proposed and reframed an expected utility–entropy (EU-E) based decision model. Later on, a similar numerical representation for a risky choice was axiomatically developed by Luce et al. under the condition of segregation. Recently, we established a fund rating approach based on the EU-E decision model and Morningstar ratings. In this paper, we apply the approach to US mutual funds and construct portfolios using the best rating funds. Furthermore, we evaluate the performance of the fund ratings based on the EU-E decision model against Morningstar ratings by examining the performance of the three models in portfolio selection. The conclusions show that portfolios constructed using the ratings based on the EU-E models with moderate tradeoff coefficients perform better than those constructed using Morningstar. The conclusion is robust to different rebalancing intervals.

Highlights

Mutual funds have become an increasingly dominant choice for retail investors in recent years, underlined by the large number of investors who attempt to beat the market and those who seek to diversify away the unsystematic risk from their portfolio [1,2]
To examine the performance of portfolios constructed based on the expected utility–entropy (EU-E) fund rating approach, we evaluated the performance of portfolios based on the established rating approach against Morningstar ratings
We recently established the EU-E fund rating approach and showed that the fund rating approach could predict the best performing funds compared to Morningstar ratings

Summary

Introduction

Mutual funds have become an increasingly dominant choice for retail investors in recent years, underlined by the large number of investors who attempt to beat the market and those who seek to diversify away the unsystematic risk from their portfolio [1,2]. As we demonstrated that the fund rating approach based on the EU-E model could predict the best performing funds [40], it raised the question of whether investors can utilize this fund rating approach to guide their investment decisions and achieve excess returns. To further investigate the utilization of the EU-E fund rating approach to guide investment decisions, we constructed portfolios using the best ranking funds based on the established rating approach and evaluated the portfolios performance. We assume that investors utilize fund ratings to guide their investment decisions, and they only take into account the best-performing funds to construct their portfolios. We calculate the cumulative average abnormal returns of the n portfolios constructed from 5-star funds based on either Morningstar or the EU-E models at every rebalancing interval.

Stability of Fund Ratings Based on the EU-E Decision Model and Morningstar

Findings

Conclusions