The Performance-Weighted Mutual Fund Strategy

There are a number of mutual fund strategies to estimate the value of the holdings in a fund's portfolio. Some analysts use price-weighting, some use capitalization-weighting and some use performance-weighting. With a performance weighted mutual fund or mutual fund chart, the only factor being considered is return on investment, or price to earnings ratio. The performance weighted strategy assumes that, other things being equal, the security with the best price to earnings ratio (P/E) is a better purchase.

Finding Price to Earnings

Determining the price to earnings ratio on a security is actually a bit more complicated than you would assume. It starts with the basic factors of market price per share and earnings per share. However, an analyst or fund adviser has to consider the range he or she will be using. Every security will have a different P/E today than it will in a month from now. Would you like to consider the whole month? The last three months? The last three years? These items become more important when it is time to weight the performance of the security. 

Weighting a Fund

Weighting has a few meanings in terms of evaluating a security. First, weighting means simply comparing two securities or two funds based on a single measure; in this case, that measure is performance. Second, and more narrowly in this case, weighting means giving more merit to recent performance than performance far in the past. For example, if you are determining the P/E on a security for the past three years, it is possible the security did very well two years ago, tanked in the last year, and still has a good P/E. Weighting the analysis means the last year, wen the security tanked, will have a greater impact on the P/E the analyst uses than the previous two years when the security took a bullish run.

Advantages of the Performance-Weighted Strategy

When you weight performance, you get a clearer picture of trends with a security. Instead of simply thinking of the investment in terms of how it is trading today, you are accounting for the various levels it traded at in the past. This can give insight into whether the stock is a valuable investment or whether, in some cases, it is overpriced. A performance-weighted mutual fund will try to focus on those valuable investments and ignore trends or constant growth securities that may be overpriced.

Disadvantages of the Performance-Weighted Strategy

The main challenge with the performance-weighted model is that it only works when all other factors are equal. For example, a strong stock and a strong bond will never have the same P/E; the stock should always be higher. However, this does not necessarily mean the stock is a better investment. The risk levels between the two are so different that they cannot be compared in terms of performance alone. Further, the P/E on a share trading at $5 may be the same as a share trading at $500, but the clientele purchasing each will be different. Performance weighting, then, must be part of a larger analysis to be accurate.

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