A mutual fund's performance is always expressed in terms of its total return, which is the sum of the change in a fund's net asset value (NAV), its dividends and its capital gains distributions over a given period of time.
Generally, the time periods used by investment research analysts are year-to-date, one year, three years, five years and 10 years. Of most relevance to investors are the five and 10-year periods, with the latter time frame being considered the best measure of an investment manager's ability to perform.
Total return figures are calculated and expressed net of a fund's expenses, i.e., those included in a fund's expense ratio. Investors in load-funds should note that in fund literature and the financial press, generally, the performance of these funds is reported without adjusting for the impact of the sales charges. However, 12b-1 fees, because they are part of the expense ratio calculation, are included. Morningstar and Value Line mutual fund reports all provide load-adjusted total return figures.
A fund's true performance potential needs to be evaluated within the context of the market environment prevailing during the different periods used. If, in 2006, we look back at total returns for one year (2005), three years (2003 to 2005), five years (2001 to 2005) and 10 years (1996 to 2005), we are going to get a variety of percentages.
For example, as of March 2006, using a three-year measurement picks up one excellent year (2003) and two fairly good years (2004 and 2005), all of which produce an overly positive take on a fund's total return. A five-year measurement picks up two very poor years (2001 and 2002) and the aforementioned good years (2003-05), making it more representative in terms of fund performance.
Obviously, 10-year measurements of performance will most likely cover a mix of market conditions and translate into a more reliable long-term indicator of a fund's investment management abilities.
Annualized Versus Actual Total Return
For any time period of more than one year, a fund's total return is "annualized" and so reported. Let's assume that the XYZ Fund is said to have an average annual five-year total return of 12%. This does not mean that XYZ delivered an actual annual total return of 12% in each of the five years measured - the 12% is an average, or annualized return. (To get a better understanding of this concept, see All Returns Are Not Created Equal.)
While helpful as a general indicator of fund performance, the prudent fund investor will also want to look at the fund's year-to-year, or inter-annual, actual total returns. There is more investment quality reflected in a fairly steady yearly performance rather than one with drastic ups and downs. If we use an amusement park analogy for gauging the investment quality of a fund's performance, a smooth ride on a merry-go-round would be preferable to the thrills of a ride on a roller coaster.
To illustrate this point, let us revisit XYZ Fund's five-year annualized total return of 12%. It would be a fairly reliable performance indicator if XYZ had the following year-to-year results over five years: +9%, +13%, +10%, +15% and +13%. However, XYZ's 12% annualized five-year total return would not look very reliable with these inter-annual total returns: +58%, +9%, +3%, -2% and -8%.
New Funds and Managers Without a Track Record
Unless there are some compelling special circumstances, simply avoid funds with fewer than three years of performance. New managers need time to prove themselves. There are dozens of good funds with long-term track records and managers that have proved themselves. With some exceptions, when it comes to your hard-earned dollars, invest with reliable veterans rather than with the new kids on the block. (For more on this topic, see Has Your Fund Manager Been Through A Bear Market?)
The Performance Disclaimer
In the investment business, the oft repeated statement that "performance data represents past performance, which is no guarantee of future results" has become a cliché. Of course, the real purpose of this statement is to provide liability protection to purveyors of investment products as opposed to providing guidance to investors. That said, past performance is what we have to work with - and it's much better than a crystal ball. The real problem here is the phrase, "no guarantee," which should alert investors to the simple fact that future investment performance is subject to many variables.
Benchmarking is one of the most important aspects of a mutual fund's total return performance. A fund's performance metrics only have meaning if they are compared to appropriate "guideposts," or benchmarks. In the financial field, there are dozens of indexes against which analysts measure the performance of any given investment.
Examples of well-known and much used market indexes include:
- Standard & Poor's 500 Index: Includes 500, mostly large U.S. companies representing a range of industries and sectors of the U.S. economy. The S&P 500 is commonly used as an overall stock market benchmark as well as that for large cap stock mutual funds.
- DJ Wilshire 5000 Index: Includes more than 6,700 U.S. companies of all sizes and is considered the broadest measurement of the U.S. equity market. The Wilshire 5000 is used as a benchmark for the American stock market and all cap stock mutual funds.
- Russell 2000 Index: This index measures the performance of the 2,000 smallest stocks in the U.S. market and is used as a benchmark for small cap stock mutual funds.
- Morgan Stanley Capital International EAFE Index: The broadest international stock benchmark, the MSCI EAFE measures the performance of stocks in Europe, Australia and the Far East. There are additional MSCI indexes for other regions, specific countries and foreign market segments.
- Lehman Brothers Aggregate Bond Index: This index is considered the best overall benchmark for the U.S. bond market.
In addition to formalized benchmarks, mutual funds are also compared to their peers, or peer groups, and relevant fund categories. For example, it is common for investment research materials to compare a mid cap value stock fund to funds similar in nature (peers or peer group) as well as an index that is used for the mid cap value stock category as a whole. (For more insight, read Benchmark Your Return With Indexes and Is Your Portfolio Beating Its Benchmark?)
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