Risk-adjusted return provides a simple means of comparing similar mutual funds on a common basis. As similar mutual funds usually are not equivalent in terms of risk, simply comparing their average returns is not a valid means of selecting the best mutual fund. Similar mutual funds are those that are in the same category or asset class. In other words, compare large cap value to large cap value, technology to technology, emerging markets to emerging markets and so on. It's important to understand that using risk-adjusted returns to compare mutual funds in different categories may be interesting, and useful in getting a feel for the relative risk of different asset classes, but it's not a valid means of selecting mutual funds, as mutual funds in different asset classes are not alternative investments, they are complementary investments in a well-diversified portfolio.
The problem is that market timing it not illegal. The problem occurred when the mutual fund stated in it's prospectus that it did not allow that activity while they secretly allowed privileged investors to do it anyway. For instance, large hedge funds would move millions of dollars into a mutual fund one day and sell it out the next. This gave the mutual funds increased fees while hurting the return of their regular investors. In response, the SEC has proposed a number of rule changes. One rule would require mutual funds to impose a redemption fee when a sale occurs within five days of purchase. Unfortunately, many mutual fund companies have seen this as an opportunity to impose new fees that make it harder for you to move your money elsewhere. So the SEC's involvement has had the unintended effect of increasing costs and reducing flexibility for the average mutual fund investor.
Modigliani and Modigliani recognized that average investors did not find the Sharpe ratio intuitive and addressed this shortcoming by multiplying the Sharpe ratio by the standard deviation of the excess returns on a broad market index, such as the S&P 500 or the Wilshire 5000, for the same time period. This yields the risk-adjusted excess return. This, too, is a significant and useful statistic, as it measures the return in excess of the risk-free rate, which is the basis from which all risky investments should be measured. However, this still falls a bit short of being truly intuitive to the average investor, and excess returns are not part of the mutual fund data that is ordinarily published.
Not only investors and those nearing retirement can benefit from a mutual fund, the young generation can, too. Those single individuals or single parents or young individuals who just want to start all over again can do so with a mutual fund. Mutual funds accept small investments even those under a thousand dollars. Though you start small, there are dozens of investors who pool their investments together with yours, all for one purpose, to make more money.
Not much is lost by computing risk-adjusted returns in this manner and the result is much more useful to the general public. What is lost is the measure of excess returns, but that isn't the objective of computing risk-adjusted returns. Rather, the objective is to compare mutual funds on a relative basis in terms that are meaningful to the average investor. As long as the funds that are being compared are similar in nature and their returns cover the same period of time, using the risk-adjusted return for comparing mutual funds is reasonably reliable basis for selection that will lead you to the same selection as the Sharpe ratio more often than not. However, as the possibility of a sub-optimal selection exists, it's best to use go one more step with the quantitative analysis.
The financial services industry's goal is to reduce their costs and increase client retention by making it harder for you move your money elsewhere. My goal is to manage my clients' money in such a way that protects what they've worked so hard to acquire without limiting their flexibility.
The problem is that market timing it not illegal. The problem occurred when the mutual fund stated in it's prospectus that it did not allow that activity while they secretly allowed privileged investors to do it anyway. For instance, large hedge funds would move millions of dollars into a mutual fund one day and sell it out the next. This gave the mutual funds increased fees while hurting the return of their regular investors. In response, the SEC has proposed a number of rule changes. One rule would require mutual funds to impose a redemption fee when a sale occurs within five days of purchase. Unfortunately, many mutual fund companies have seen this as an opportunity to impose new fees that make it harder for you to move your money elsewhere. So the SEC's involvement has had the unintended effect of increasing costs and reducing flexibility for the average mutual fund investor.
Modigliani and Modigliani recognized that average investors did not find the Sharpe ratio intuitive and addressed this shortcoming by multiplying the Sharpe ratio by the standard deviation of the excess returns on a broad market index, such as the S&P 500 or the Wilshire 5000, for the same time period. This yields the risk-adjusted excess return. This, too, is a significant and useful statistic, as it measures the return in excess of the risk-free rate, which is the basis from which all risky investments should be measured. However, this still falls a bit short of being truly intuitive to the average investor, and excess returns are not part of the mutual fund data that is ordinarily published.
Not only investors and those nearing retirement can benefit from a mutual fund, the young generation can, too. Those single individuals or single parents or young individuals who just want to start all over again can do so with a mutual fund. Mutual funds accept small investments even those under a thousand dollars. Though you start small, there are dozens of investors who pool their investments together with yours, all for one purpose, to make more money.
Not much is lost by computing risk-adjusted returns in this manner and the result is much more useful to the general public. What is lost is the measure of excess returns, but that isn't the objective of computing risk-adjusted returns. Rather, the objective is to compare mutual funds on a relative basis in terms that are meaningful to the average investor. As long as the funds that are being compared are similar in nature and their returns cover the same period of time, using the risk-adjusted return for comparing mutual funds is reasonably reliable basis for selection that will lead you to the same selection as the Sharpe ratio more often than not. However, as the possibility of a sub-optimal selection exists, it's best to use go one more step with the quantitative analysis.
The financial services industry's goal is to reduce their costs and increase client retention by making it harder for you move your money elsewhere. My goal is to manage my clients' money in such a way that protects what they've worked so hard to acquire without limiting their flexibility.
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Frank Miller has a Debt Consolidation Blog & Finance, these are some of the articles: Applying For Canadian Business Loans You have full permission to reprint this article provided this box is kept unchanged.
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