Build PortfolioMutual Funds Rating Methodology
FundScope's rating methodology is based on the following criteria and assumptions:
Performance Ratings
Performance ratings are essentially based on the five-year rate of return.
Ratings are obtained by ranking funds in descending order. Diamonds are assigned based on the following classification:
- Five diamonds: Funds with returns exceeding the category average by more than two standard deviations
- Four diamonds: Funds with returns exceeding the category average by more than one standard deviation (but less than two standard deviations)
- Three diamonds: Funds with returns exceeding the category average by less than one standard deviation
- Two diamonds: Funds with returns lagging the category average by less than one standard deviation
- One diamond: Funds with returns lagging the category average by more than one standard deviation.
Risk
FundScope's risk rating methodology is unique in that it incorporates both a statistical measure of volatility and mutual funds' performance during recent market corrections. The standard deviation measures the variation between the average 5-year return of a mutual fund and its monthly returns. As such, funds with higher standard deviations are considered more volatile and riskier. So to complete the first component of the risk rating, we score funds on a scale of 1 to 5 based, on 5-year standard deviation, and following the same classification rules used for performance ratings.
In addition, we measure the performance of mutual funds during the months of negative returns for the category. We call this down market performance. To complete the second component of the risk rating, we score funds on a scale of 1 to 5, on the basis of their down market performance, and following the same classification rules used for performance ratings.
Next, we calculate the risk rating as a simple average of the two scores(volatility and downmarket performance).
Cost
To derive a cost rating, funds are ranked by their management expense ratios (MER). Diamonds are assigned and following the same classification rules used for performance ratings.Composite ratings
How much weight to assign to each of the three factors is, to a large extent, determined by historical performance patterns. Because cost is the only predictable element in a fund's future performance, we assign the highest weight to it, with varying degrees, depending on the categories of funds. Cost is a forward-looking measure.
For all equity and balanced funds, we assign twice as much weight to cost (i.e. 50%) as to each of returns and risk (25% each). For fixed income funds, where there is less emphasis on management and style, we assign a 70% weight to cost vs. 15% to each of risk and returns. For money market funds, we assign a 70% weight to cost, a 30% weight to historical returns and no weight to risk. Given the short average duration of money market funds, performance volatility is minimal, assuming that money market fund managers adhere to stated objectives and do not engage in speculative activities.