Measuring mutual fund performance using return-based style analysis

How to measure the performance of mutual funds is the main question that perplexes the fund industry. We show that the measure proposed by Sharpe (1992), which is derived from return-based style analysis, is superior to other measures. We formally develop the econometric methodology to implement it and show that the measure has several advantages because of its quadratic programming estimation technique instead of the regression method of traditional measures. We empirically examine the mutual funds in US using the equity mutual fund data from Bloomberg and Morningstar database. The results show that the average performance of these funds in the last three years of the sample period is around zero after adding back management fees. However, small-cap funds are able to deliver positive performance even after deducting management fees. At the same time we observe that the higher performance of small-cap funds is associated with the higher investment risk in that group of funds.