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.