Glossary of Terms

Various Terms you need to know:

Returns-Based Style Analysis (abbrev. RBSA):

Instead of just believing that a mutual fund is a "Large Cap" fund, for example, you can analyze the past performance returns of the fund, and compare them to a set of indexes. By finding which index the fund is most correlated with, you can determine whether the fund is "acting like a large cap" or like something else. BigCo might call the fund a "large cap" duck, but it might not quack like a duck on closer RBSA inspection.

Style Drift:

If a mutual fund is classified in one asset class, "Large Cap" for example, but it's best fit index after RBSA analysis shows it is most correlated with a "Mid-Cap Index", then the fund is "style drifting". It has drifted from it's target style and asset class.

R-squared:

R-Squared, or correlation coefficient, is a statistical measure that compares a fund's movements to a benchmark index. If you have a high R-Squared value then the fund is highly correlated with the index. Every mutual fund has an index that is considered a "best fit index" when analyzing the fund to a "set of indexes". The "best fit index" would be the index with which the fund has the highest calculated R-Squared value.

An R-squared value of 1 means "perfectly correlated" to the specified index, and is usually an ETF or index fund. The closer you are to 1 the more correlated the fund and index. For some reason, Morningstar normalizes the R-squared to 100 instead of 1. So their perfect correlation would be 100.

Alpha:

Alpha is a measure of an investment's performance on a risk-adjusted basis. Alpha looks at the performance of a mutual fund or investment and compares the risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark is alpha. If you have a positive alpha, then the investment is outperforming the benchmark index. If you have a negative alpha, then the investment is underperforming the index.

Many mutual funds have a negative alpha for their benchmark index. This means that the fees you are paying the fund manager are "not worth it" since you'd be better off buying an ETF or Index Fund instead of paying fees to the fund manager to underperform the index.

Beta:

Beta measures the volatility of an investment compared to the market. Beta is calculated using regression analysis against an index that represents the market. By definition, the market has a beta of 1 while individual investments have betas either above 1 or below 1.

A beta of exactly 1 means that the investment's price will move in exactly with the market. A beta of less than 1 means the investment will be less volatile than the market. Finally, a beta of more than 1 means the investment's price will be more volatile than the market. For example, if a fund's beta is 1.1, it's 10% more volatile than the market.

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