Mutual Fund Ratings and Performance Persistence

Abstract

This paper studies the persistence of mutual fund performance. Academic research often focuses on fund returns, sometimes adjusted for style and market cap biases. Because fund rating systems play a central role in the asset management industry, we consider another approach in this paper. Using a Markov modeling of these ratings, we illustrate that the persistence of the performance is relatively poor with respect to the time horizon of investors. We show that two facts may explain these results. First, the rating system is not necessarily time-homogeneous. Second, the importance of style is crucial when comparing the ratings of mutual funds. However, we show that it is extremely difficult to characterize quantitatively the style of a mutual fund. We conclude that fund selection is more art than science, and that quantitative analysis must be combined with qualitative insight.

Keywords: Mutual funds, rating system, style analysis, Markov chain, active management

JEL Classification: G11, G24, C53