By Charles | Published: June 30, 2013

Originally published in July 1, 2013 Commentary

The following is a summary of definitions of the various terms tabulated in the MFO rating system. A recap of the system’s methodology can be found in David’s June 2013 commentary under Introducing MFO Fund Ratings. For those interested in the mathematical formulas used in the system, they can be found on the MFO Discussion board under A Look at Risk Adjusted Returns .

The definitions are listed in order of tabulation heading:

Indicates a fund’s broad investment approach. The MFO rating system groups funds into three types: Fixed Income (FI), Asset Allocation (AA), and Equity (EQ). Asset allocation funds typically manage a mixed portfolio of equities, bonds, cash and real property. The so-called balanced funds are in this type. Typically, but not always, equity funds principally invest in stocks, while fixed income funds principally invest in bonds.

A fund’s current investment style as defined by Morningstar. There are more than 100 such categories, like large blend, long government, and market neutral.  The MFO rating systems excludes following categories: money market, specific commodities, volatility, bear market, and trading vehicle.

A fund’s average rate of return each year over period evaluated. For example, APR for 10 year funds is the average percent return for each of 10 years. It is an abstract number, since actual annual returns can be well above or below the average, but annualizing greatly facilitates comparison of fund performance. APR is equivalent to CAGR, or compound annual rate of return. It reflects reinvestment of dividend and capital gain distributions, while deducting for fund expenses, fees, and front-loads.

The percentage of greatest reduction in fund value below its previous maximum over period evaluated. MAXDD can be the most frightening of a fund’s many statistics, but surprisingly it is not widely published. Many top rated and renowned funds incurred maximum drawdowns of -60% or worse in 2009. The date (month/year) of MAXDD occurrence is also tabulated in the MFO rating system.

A measure of fund volatility. The higher a fund’s standard deviation, the more its return has varied over time. That can be both good and bad, since a rise or fall in value will cause standard deviation to increase. Typically, but not always, money market funds have lowest standard deviations, stocks funds have highest, while bond funds are in-between. In the MFO rating system, STDEV indicates the typical percentage variation above or below average return a fund has experienced in a year’s time. On good or bad years, variations from average returns have been two or three times the standard deviation, and every now and then even more.

Another measure of fund volatility, but it measures only downward variation. Specifically, it measures a fund’s return below the risk free rate of return, which is the 90-day T-Bill rate (aka cash). Money market and very short term bond funds typically have downside deviations very close to zero, since they normally return T-Bill rate or higher. Stock funds typically have the highest downside deviations, especially in bear markets. In the MFO rating system, DSDEV indicates the typical percentage decline below its average excess return a fund has experienced in a year’s time.

A third measure of fund volatility and the most direct measure of a fund’s bouts with declining (and uncomfortable, hence its name) performance. It measures both magnitude and duration of drawdowns in value. A fund with high Ulcer Index means it has experienced deep or extended declines, or both. Ulcer Index for money market funds is typically zero. During bull markets, stock funds too can have a low Ulcer Index, but when the bull turns, watch out. In the MFO rating system, UI indicates the typical percentage decline in value a fund has experienced at some point during the period evaluated.

A measure of risk adjusted return, which is to say it helps quantify whether a fund is delivering returns commensurate with the risk it is taking. Specifically, it is the ratio of the fund’s annualized excess return divided its standard deviation. A fund’s “excess return” is any amount above risk-free investment, which is typically 90-day T-Bill. Sharpe is best used when comparing funds of same investment category over same evaluation period. The higher its Sharpe, the better a fund is performing relative to its risk, or more precisely, its volatility.

Another measure of risk adjusted return, but in this case it is relative to the amount of downside volatility (DSDEV) a fund incurs. It is a modification of the Sharpe intended to address a criticism that Sharpe unfairly penalizes so-called good volatility (ie. rising value), which investors don’t mind at all.  In other words, a fund that goes up much more than down may be underappreciated in Sharpe, but not Sortino. Like Shape, Sortino is best used when comparing funds of same investment category over same evaluation period.

A third measure of risk adjusted return. Like Sharpe and Sortino, it measures excess return, but relative to its typical drawdown. After the 2000 tech bubble and 2008 financial crisis, which together resulted in a “lost decade” for stocks, investors have grown very sensitive to drawdowns. Martin excels at identifying funds that have delivered superior returns while mitigating drawdowns. It too is best used when comparing funds of same investment category over same evaluation period – this very comparison is the basis for determining a fund’s Return Group rank in the MFO rating system.

The score or ranking of a fund’s performance based on Martin Ratio relative to other funds in same investment category over same evaluation period. The evaluation periods are 1, 3, 5, 10, and 20 years, as applicable. Funds in the top 20 percentile are placed in return group 5, while those in bottom 20 percentile are in return group 1. MFO “Great Owl” designations are assigned to funds that have earned top performance rank for all evaluation periods 3 years or longer, as applicable.