Category: Guides

Evaluating the Performance of Your Mutual Funds

When choosing which mutual fund to invest your money in, you may go off the one-year return rates, and arrive at the conclusion that a particular fund was very successful. However, it is not enough to merely look at the return rates for one year. Instead, you should take a look at a couple of years back, and even perhaps the whole history of the fund.

For example, if a particular fund boasted stellar returns last year, but we look at the average returns over the last 3 or 5 years, and they turn out to be much lower than the one year return rate, it is possible that the fund actually lost money in one or more of the years in question, even though the average return percentage remained positive.

mutual fund analysis

Relative Performance

The way in which we judge the performance of a mutual fund is fundamentally relative, and there is no empirically correct way to do it. The best way to gauge a mutual fund’s performance is, therefore, not to rely on the return percentages, but to compare its performance with other relevant data, in particular, with the performance of the appropriate stock index and with other similar funds.

mutual fund performance

Firstly, in order to see whether the mutual fund performed well, we need to ask the question of whether it accomplished its mandate. The reason people invest in mutual funds is that they expect it to be able to secure better returns than an index fund, which passively tracks the stock market. This is called ‘beating the market’, and it is very tricky to do consistently.

Market Benchmark

In fact, according to the efficient market hypothesis, it is impossible to consistently beat the market, since all the information about the future price of any financial instrument, be it stocks, bonds, or derivatives, is already contained within the price of the instrument itself. There is a wealth of evidence to support this claim, but it has still not been accepted as an unquestionable rule.

Going off the efficient market hypothesis, it is a good idea to compare the performance of a mutual fund with the relevant stock index. Large equity funds are most often compared with the S&P 500, whereas small equity funds are compared to the Russell 2000. Comparing the performance of a mutual fund with the wrong index can yield incorrect results, so it is important to know which index to compare it to.

s&p performance

This benchmark is even more effective when another layer of scrutiny is added. When considering the performance of a mutual fund, it is also important to take a look at how other funds in a similar family performed in comparison to the index. If we find that the fund we are evaluating stuck with the herd in terms of the investments it made, and the returns are similar, this should be seen as an average performance.

If, however, the fund we are evaluating chose to invest in different stocks, there can only be two results. Either it fared better than its peers by virtue of being able to select better stocks, or it fared worse, because its investment strategy didn’t pay off. Naturally, the goal of any investor is to invest in a fund that can maximize the returns by selecting stocks well, thereby beating the market.

However, even when comparing the mutual fund in question with its peers, there are data points which can be misleading. Fund companies paint a rosier picture of their overall performance by shuttering those funds which have lost money. That way, the composite performance of the fund company is improved, because the losers are removed from the statistics.

Full Performance Analysis

Thus, a general conclusion can be reached when the method of evaluating the performance of mutual funds is concerned. The trick to evaluating performance accurately is not to look at discrete data points in isolation, but rather to correlate as many points of data as you can, in order to have a clear picture.

Even though technically the management of your mutual fund works for you, their goals and your goals are not always aligned, since they get paid whether or not they were able to deliver results. Furthermore, their aim is to keep you invested in the fund for as long as possible, so they have developed ways of papering over their mistakes in order to make it look as though things are fine, even when they’ve made mistakes. Therefore, you would do well to constantly question the performance of your fund, and not to take management at their word.

The Fees and Costs Associated with Mutual Funds

It is important that a would-be investor be aware of all of the costs that come with investing in a mutual fund before deciding whether they are the right option for their needs. These costs are not always laid out as clearly as is the case with regular stocks or bonds.

With stocks, you are expected to simply pay a broker the fee you’ve agreed upon, and that’s it, whereas with buying stock in mutual funds, you may also have to pay a fee, but there may also be other costs, some hidden with obscure language that may be difficult for an average investor to follow. However, every mutual fund prospectus must spell out the fee schedule in a table that is to be updated yearly.

Fee Categories

There are two main categories in which mutual fund fees may be subdivided. Firstly, there are ongoing annual fees, which keep you invested in the fund. These are expressed in terms of the expense ratio, also referred to as the management expense ratio (MER). These expenses are usually taken out of the return you get from your investment, instead of being billed to you directly. This fee which reduces your return can further be subdivided into two basic fees.

Management Fees

Firstly, there are hiring costs, more commonly known as management fees, which usually range from 0.5% to 2% of the assets. This is the main reason why mutual fund managers are exceedingly wealthy, since even 1% of such vast sums of money amounts to very significant numbers indeed. MInd you, these fees are paid out to the fund manager regardless of the fund’s performance, so it is questionable how a fund manager earns their fee if they have not secured significant returns for their investors.

management fees

In fact, it has been shown repeatedly that managed funds such as mutual funds are unable to consistently beat the market in terms of the return they can generate for their investors. This is especially true when we take into account the reduction of returns because of all of the fees the management extracts.

Distribution and Service Fees

The other part of the expense ratio consists of what are usually called distribution and service fees, which go toward paying brokerage commissions and advertising the mutual fund. When the fund management buys or sells some fund assets, the fees that are incurred get passed down to investors. Furthermore, by buying stock in a mutual fund, you are also paying for it to market itself to other investors. This advertising takes the form of prospectuses, billboards, commercials, and other means of promotion.

These fees are regulated by law, and cannot exceed 0.75% of any given fund’s net average assets per year. Furthermore, service fees which are used for advertising purposes cannot exceed 0.25% of average net assets per year. In the US, these fees are known as 12b-1, and if you want to learn more about them, you would do well to look the code up.

Loads and Shareholder Fees

The other broad family of fees are so-called loads and shareholder fees. Loads are the fees the fund uses to pay the broker who sold you shares in the mutual fund. Shareholder fees are the other costs that come with the transaction through which you buy or sell shares in a mutual fund, and these are billed directly to the shareholder.

shareholder fees

Sales loads can further be subdivided into front-end loads and back-end loads. Front-end loads are the fees that you are expected to pay at the moment of buying mutual fund stock. These are usually taken out of your total investment in the fund, and are usually calculated as a percentage of the investment.

Back-end loads are paid when you want to sell your shares in a mutual fund, and these are a bit more tricky. These are designed to incentivize you to keep owning the shares for a long period of time, since they are only charged if you sell your stock within a certain time of buying them. If you sell the stock after the specified time, these costs are reduced to 0%.

Mutual funds usually charge a combination of front-end and back-end loads, as well as all the other fees we’ve discussed previously. These are often an untraversable maze for the average investor, and they are often not worth the return you get in the end. That is why it is especially important that you choose the mutual fund you end up investing in well. These fees can be calculated by handy online tools, to help you keep abreast of what you should expect to pay. A good example of this is Finra’s Fund Analyzer.  

Choosing a Mutual Fund

As discussed previously, it is very important that you choose the right mutual fund, for several reasons. Firstly, you need to take into account its business model, as well as the fees and costs involved with holding stock in such a fund. Secondly, and probably more importantly, you need to define what your financial goals are, i.e., why you are investing in the first place.

You may want to put all your profits into your current account, in order to spend it on everyday expenses. This would be considered a s short-term investment. However, many people use mutual funds as a means of securing their long-term financial future, such as planning for retirement, or making a college fund for their child.

Depending on the reason for investing there are several different types of fund to choose from. If you needed cash for short-term spending, you would do well to invest in a money market fund. For spending in a few years’ time, bond funds are the best choice, and finally, for long-term investments, stocks funds are the best bet.

Types of Mutual Funds

Another important consideration when considering the type of fund you want to invest in is your risk tolerance. If you think you would be able to afford and cope with dramatic swings in portfolio value, for example, you may want to invest in stock funds instead of bond funds. If you are more conservative in your risk tolerance, the better choice would be investing in a bond fund. The most conservative choice is the money mutual fund, which is also considered to be something of an alternative to simply holding cash.

types of mutual funds

The other main aspect to choosing a mutual fund is actually finding one that suits you. Finding mutual funds has been simplified considerably by the advent of the internet. A simple Google search using the search term ‘mutual fund’ will yield millions of hits, and the most reputable funds will likely emerge among the top results.

There are also other online services and resources which may be able to help you with your choice. You can use sites such as Morningstar and Kiplinger to research mutual funds, since they carry a lot of information that is up-to-date and reliable. Also available is the Mutual Fund Education Alliance (MFEA), which is a non-profit trade association which provides search tools that allow you to find no-load funds.

Niche sites can also be useful, if you can find one that aligns well with your needs and investing philosophy. LipperLeaders, for example, is a company owned by Thomson Reuters, which evaluates funds on the basis of five metrics considered most important to the functioning of mutual funds. They call these metrics ‘Leaders’. They include the total historical return, consistency of returns, preservation of capital, expenses, and tax efficiency.

Buying Mutual Funds

Once you have found a fund that aligns with your interests, the next question is how the procedure for actually buying into it works? There are many ways you can come into possession of mutual fund stock. You could buy stock through a broker, a bank, an insurance agent, or a financial planner. These usually extract a fee in order to to this on your behalf, but if you want to avoid these, there are funds which also sell stock directly, and charge no fees to do it (other than the stock price, naturally).

There are also low-fee programs which offer stock in many different mutual funds in one place. These are often referred to as ‘fund supermarkets’, and they even offer record keeping services that keep track of all the purchases you made through them, even if you buy into different fund families. Some examples of ‘fund supermarkets’ include Schwab’s OneSource, Vanguard’s FundAccess, and many others.

vanguard funds

Once you have found a mutual fund you are interested in investing in, you should keep note of the share price. The share price for a mutual fund is calculated based on its net asset value (NAV), which is the fund’s assets minus its liabilities. NAV per share is the value of one share in the mutual fund, and this is the first number available to the potential investor when researching mutual funds. As any share price, the NAV per share fluctuates in value daily, as the holdings and liabilities of the company change.