A new way of evaluating mutual fund performance is catching the attention of a number of major fund firms, The Wall Street Journal reports.

Mutual funds are typically ranked based on their past performance against a set benchmark. A new method, contained in a study by Marcin Kacpercyzk of the University of British Columbia and Clemens Sialm and Lu Zheng of the University of Michigan, is taking a different tack.

To assess performance, the new approach calls for the comparison of the fund return versus returns of its past holdings. It looks at statistics such as stock trades and transaction costs to measure a portfolio manager's stockpicking skills.

In addition, the method attempts to determine the impact of factors such as the exact timing of stock trades, transaction prices and costs.

The study, which covered monthly return data for over 2,500 US equity funds from 1984 to 2003, zeroed in on the concept of a return gap, or the difference between a fund's current returns to investors and returns on a holdings portfolio. To arrive at the return gap, expenses are deducted from the holdings portfolio.

"Many mutual-fund studies use holdings data to analyze the performance and strategies of mutual funds," the authors said. "We show that a large amount of information is lost by only considering the holdings. The return gap between investor and holdings return is persistent and helps predict future performance."

The method has drawn interested glances from fund managers at major companies in the US and Canada, including the Vanguard Group, Kacpercyk told The Journal.

Not everyone is impressed with the method, however. Russell Kinnel, director of mutual-fund research at Morningstar, said the approach "sounds pretty flawed" because the study looks mainly at short-term trading results.  

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