For this ranking, mutual funds first are ranked by the upside-potential ratio of the fund's style benchmark. The reason for this was to get away from focusing on the return the manager earned over a short period of time as a predictor of future performance. It was my belief that creating a style benchmark for each fund, a la Bill Sharpe, would provide more stable estimates of risk and return. Rather than calculate the average return of the fund's style benchmark, I proposed a calculation called the upside potential that measured how often the manager exceeded a minimum acceptable return of 8.6% and how far the fund got above 8.6%.
As a second step, funds are selected that beat their style benchmark on a risk-adjusted basis, i.e., had a positive Omega excess return. (Free software for making these calculations is available at www.sortino.com; click on "new book.")
In the period ended Sept. 30, the top-ranked large-cap growth fund in Table 1 is Capital Research & Management Co.'s AMCAP: one of the few funds in this category with more upside potential than downside risk, and an Omega excess return of 7.8%. The Fidelity Advisor Growth Opportunities fund demonstrates the importance of combining the U-P ratio with the Omega excess return. The fund ranked second by U-P ratio, but had a -13.5% Omega excess return. That means a passive set of indexes that replicated the fund's style would have produced 13.5% more on a risk-adjusted basis.
Among large-cap value funds, Fidelity Value has the highest U-P ratio with a positive Omega excess return. But Dodge & Cox has almost the same U-P ratio, with a 10.2% Omega excess. Therefore, Dodge & Cox has the better combination of U-P and Omega excess in that category.
In the small-cap growth category, Fidelity Small Cap Select heads the list. However, Vanguard Explorer has almost as high an upside-potential ratio, with an Omega excess of 13.4%. While Fidelity Mid Cap has an even higher Omega excess return (15.7%), the R-squared is only 0.74. Meaning, the model hasn't really captured the style.
