Systematic performance analysis of mutual funds is a must.

Generally, performance is expressed relative to certain benchmarks” which may give a clearer view of management abilities, but the whole picture is incomplete if the dimension of investment risk is ignored. Here the widely-used concept of “volatility” has to be reviewed, which seems in-complete on theoretical as-sumptions as well as empirical results.

Therefore, getting a complete picture requires comprehensive measurement of risk and return under different market conditions. Consequently, our company created the concept of positive and negative elasticities, which allows in-depth analysis of a fund’s return behaviour in positive or negative market cycles. What we term a “V-Fund” will consistently outperform its benchmark in bull markets and significantly beat the average in bear markets. In contrast, what we call “A-Fund” will show severe underperformance in both bull and bear markets.

The scatter graph shows how the concept of relative elasticities can be used to analyse funds within certain market segments as well as screen large universes of mu-tual funds. In the graph, each point in the North/West segment represents a “V-Fund”. This has a very attractive risk/ return profile, unlike funds in the South/East corner showing an extremely poor one. These should be strongly avoided. A fund placed in the North/East corner signals aggressive investment characteristics, so it will outperform in bull markets, but incur above-benchmark loss-es in bear markets. The re-verse applies to funds in the South/ West corner, implying a more defensive investment style.

In most fund markets, the last two categories represent the majority, whereas both “V-Funds” and “A-Funds” are very rare species. Preliminary tests performed by our company clearly show that fund rankings based on the concept of relative elasticities give systematic rather than random results and can even be used to forecast future risk and return characteristics for individual funds. This new methodology has large po-tential to enhance the standard tool box ofperform-ance measurement.

Heinz Werner Rapp is a portfolio manager at FERI Trust in Bad Hamburg