The Right and Wrong of Ranks

Abstract

This article investigates the behavior of return ranks of different period lengths for four sets of consistent out- and underperformers in two well-controlled peer groups of large blend and intermediate-term bond mutual funds. It shows that short-term return ranks are increasingly biased towards the median, even when the underlying fund performance is stable. Short-term ranks thus systematically overestimate the performance of consistent underperformers and vice versa. This complicates their use for performance evaluations.

The article describes how the bias of short-term ranks arises, how it affects the practice of performance measurement both for individual funds and groups of funds, and how these shortcomings can be surmounted. In the course of doing this, the article defines a new measure of risk-adjusted performance, which assesses the strength and consistency of outperformance, and it describes a helpful improvement to Philip’s well-known statistical control chart approach to performance measurement: http://ssrn.com/abstract=371121.

Keywords: Investment performance measurement, return ranks, peer groups

JEL Classification: C58, C18, G17