Perhaps you've noticed those mutual fund ads that quote amazingly high one-year rates of return? Your first thought might be, "wow, that mutual fund did great!" Well, yes it did great last year, but then you look at the three-year performance, which is lower, and the five year, which is yet even lower. What's the underlying story here? Let's look at an actual example from a large mutual fund's performance:

 1 year return 3 year return 5 year return 53% 20% 11%

Last year, this mutual fund had excellent performance, returning 53% to investors. But, over the past three years the average annual return was just 20%. What did the fund return in years 1 and 2 to bring the average return down to 20%? Simple math shows us that the fund made an average return of 3.5% over those first two years: 20% = (53% + 3.5% + 3.5%)/3. Since this 3.5% figure is only an average, it is very possible that the fund lost money in one or more of those years. (See also the Investopedia tutorial Fund Performance Metrics.)

It gets more dismal if we look at the five-year performance. We know that in the last year the fund returned 53% and in years 2 and 3 we are guessing it returned around 3.5%. So, what happened in years 4 and 5 to bring the average return down to just 11%? Again, by doing some simple calculations we find that the fund must have lost money, on average -2.5% each year of those two years: 11% = (53% + 3.5% + 3.5% - 2.5% - 2.5%)/5. With that in mind the fund's performance doesn't look quite so impressive.

For the sake of simplicity in this example, and besides making some big assumptions, we haven’t calculated compound interest over time. The point, however, was not so much to be technically accurate but to demonstrate the importance of taking a closer look at performance numbers and comparing them across years. A fund that loses money for a few years can bump the average up significantly with one or two strong years.

## It's All Relative

Knowing how a fund performed in isolation is not very helpful. Performance must be viewed as a relative issue, judged against the performance of an appropriate benchmark. For example, a large-cap equity fund would usually be compared against the S&P 500 while a small-cap equity fund against the Russell 2000 index. Comparing to the wrong benchmark can produce mismatched returns and aren’t very informative. When the fund we looked at in the example above is compared against its appropriate benchmark index, a whole new layer of information is added to the evaluation. If the benchmark returned 75% for the single-year time period, that 53% returned by the fund no longer looks quite as good. If, on the other hand, the benchmark delivered results of 25%, 5%, and -5% for the respective one, three, and five-year periods, then the fund's results look rather fine indeed.

To add another layer to the evaluation, we can consider a fund's performance against its peer group as well as against its benchmark index. If other funds that invest with a similar mandate had similar performance, this data point tells us that the fund is in line with its peers. If the fund bested its peers and its benchmark, its results would be quite impressive.

Looking at any one piece of information in isolation only tells a small portion of the story. Consider the comparison of a fund against its peers. If the fund sits in the top slot for each of the comparison periods, it is likely to be a solid performer. If it sits at the bottom, it may be even worse than perceived, as peer group comparisons only capture the results from existing funds. The risk here is called survivorship bias. Many fund companies are in the habit of closing down their worst performing funds, and when the losers are purged from their respective categories, their statistical records are no longer included in the category performance data. This makes the category averages creep higher than they would have if the losers were still in the mix.

To develop the best possible picture of fund's performance results, consider as many data points as you can. Long-term investors should focus on long-term results, keeping in mind that even the best performing funds have bad years from time to time. It is also important to keep in mind that costs and fees are not included in performance statistics, but can make a real impact on your own returns from investing in mutual funds.

Mutual Funds: Conclusion
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