The right way to measure mutual fund performance
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When you invest, you want returns. However, there are many ways to measure performance and since investing in mutual funds is what the majority of us have to do in order to achieve financial freedoms or any other goals, it is important to learn how to measure performance. Most people measure fund performance by just simply looking at its historical returns. The rationale behind it is simple, if a fund is unable to achieve satisfactory returns in the past, what makes us think that it is going to do so in the future.
However, by basing your decisions on which fund to invest simply only on a fund’s historical return is in my opinion, not a very wise action to take. Mutual fund companies know that know that past returns sell funds, precisely is the reason why advertisements in print media like newspapers and financial magazines specifically show past returns. Most may not find it easy to believe, it is actually the low expenses of a fund that is more predictive of its return, though a fund’s return is still to a certain extent reveal to you whether it is worth owning. To make an informed decision on whether a fund is good to invest for you, you need to take note of the following points,
1. What is return anyway?
We talk about returns in businesses and investments, and in many finance literature. And when we invest, we want returns, it is therefore important to know the definition of two types of returns commonly used in many places. These two are total returns and annualized returns.
Total return is simply that capital gains (or losses) in the market value of the stocks and/or bonds that the fund owns and the income that is received from those stocks and bonds. Stocks got pay dividends, though not every regular interval got, unlike bonds got a relatively stable income from coupon payments every six months.
In equation form, the total return is,
Total return = capital returns + income returns
There is another return terminology that is related to total return. An annualized return is return expressed in percentage form, over one or more years. It is sort of an average return over a period of time. The period of time can be 3, 5 or 10 years and annualized return takes into account compounding effect. A fund with a four years annualized return of 8% does not mean that it made exactly 8% every year of course since that is almost impossible in reality for a mutual fund managed by humans and given market conditions. It may made 12% in year 1, lost 29% in year 2 and then return another 40% in the last two years. The annualized return means that if you buy into the fund during year 1 and hold on to it until end of year 4; you would have like earned 8% every year on the initial capital.
2. Long term returns matter, not short term high returns.
In many mutual funds advertisements, one usually does not discover their advertised returns for more than 8 years as the figures may not look good. You need to look at the fund’s returns for at least the past 5 years and compare it with two types of benchmarks, namely its respective indexes and funds that invest in the “same area”, in order to have a better perspective on performance. For instance, almost every technology funds clocked impressive returns during the dot com bubble, lasting a few short years but their long term returns are dismay ever since the dot com bubble burst.
A fund that performs not that well in one year but do good in more than 5 years is not necessarily a bad buy since even Warren Buffett does not achieve a 20% return every year but its annualized return ever since the inception of Berkshire Hathaway is more than 20%. In the extreme end, it is not advisable to invest in a fund that performs poorly consistently over many time periods again since Warren Buffett also did not do worse than the market for most of the last 30 years.
In many cases, it is the fund manager behind the fund that matters or responsible for producing superior returns, If the feller dies or jump ship and work in other mutual fund companies, then the satisfactory return in the past 10 years will most probably not materialised in the future.
3. Indexes as benchmark to compare mutual fund returns
The most commonly used yardstick for comparing how well the mutual fund managers do their jobs is simply by comparing fund’s return to its related index. Almost every fund’s shareholder report compares its returns to one or more indexes, the misrepresentation comes when a wrong index is chosen for comparison, and it will be like comparing apples with oranges.
Stocks are classified based on many parameters, the most common of which is their market capitalisations. The S&P 500 is a good index to benchmark against when the active managed fund focus on large cap and Brand Name United States Company. Although it may not be that ideal also, since the S&P 500 index is built in such a way that companies with larger market cap make up a larger percentage of the index and hence, the performance of companies like Microsoft and Exxon Mobil and General Electric will be reflected in S&P 500 also.
Given that small cap and large cap usually go their separate ways in terms of performance given any time periods, one commonly misrepresentation used by some mutual funds companies is that comparing a large cap value fund performance with Russell 2000 – index made of small caps when it does not do well relative to the large caps index and/or its similar peers. As a result, you have to ensure that an appropriate index is used for comparing mutual funds performance.
4. Peer groups as benchmark to compare mutual fund returns
Peer groups in this case mean other mutual funds that invest a large part of in the “same area”. The same area in this case does not only refer to geographic area but also cap size, value or growth, sectors, and maybe other less commonly used parameters like dividend yields.
In some cases, using indexes only may not be effective or even non applicable, a fund that invest in technology stocks in the United States may perform worse than the S&P 500 but this index is diversified into many different sectors and the technology fund did not load up on financial stocks before the economic crisis of 2008, and hence may not do well relative to S&P 500 during years 2006 and 2007. As a result, comparing to other mutual funds that invest in technology stocks makes more sense in gaining into insight of its performance.
5. Beware of chasing after returns
I know that it does not feel good watching your large cap fund achieving negative returns or lag seriously behind other categories. This happens during the dot com bubble when technology funds do very well relative to old economy stocks. But by the time you jump inside the bubble is already waiting to be burst. In other words, there are really no clear signals on when to buy and sell this or that hot fund. When it comes to mutual fund investing, it is better to be a contrarian investor, when everyone is investing in a fund category, that means that category is about to cool off and when everyone is selling in another fund category, that means it is about to rebound to some higher prices. Note that contrarian investing does not always applies to individual stocks as some times, prices drop and remain low due to fundamental business reasons whereas a mutual fund usually holds quite a large number of stocks from many different companies. There is one investment company that blindly jumps into buying large stakes in Australia ABC Learning Centre because it is like what Warren Buffett is doing when American Express prices fall due to a scandal.
In view of the pitfalls of chasing after this or that hot fund, it is recommended that most investors construct a portfolio of funds in different categories so that in any market conditions, there are some portions of your portfolio that aren’t do too bad.
6. How much do taxes reduce returns?
There is a saying that there are only two certainties in life – one is death and the other is taxes. Returns are mentioned earlier but that does not account the “take home pay” after taxes. When capital gains are realised and income is received from either dividends or coupon payments, you have to pay taxes on them. Investing in what type of funds depends on whether you are investing through a taxable or non taxable account.
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