How To Dissect Mutual Fund Returns
While total and compound annual returns are useful, savvy
investors will look deeper, using a variety of metrics, to get a
more complete picture on mutual fund performance.
On January 1, 2006, a leading financial daily reported the
trailing 1-year and 5-year returns of Fidelity Contrafund
(Nasdaq: FCNTX), a no-load mutual fund, as 16.23% and 6.21%
respectively. While the financial daily's return information is
useful, there is more to mutual fund returns.
Is the performance of the fund superior or inferior?
How tax-efficient is the fund in delivering these returns?
Are the returns of the fund commensurate with the risk the fund
manager has taken to achieve them?
Savvy investors will seek answers to such questions when
evaluating mutual fund returns. Before getting into the
nitty-gritty of mutual fund returns, it is good to understand
what the data reported in the financial daily really mean.
Total Return
Fidelity Contra's reported 16.23% 1-year return is the fund's
total return for the December 31, 2004 to December 31,
2005 period. In practical terms, $10,000 invested in the fund on
December 31, 2004 is worth $11,623 on December 31, 2005. The
total return includes more than the increase (or decrease) in
the fund's share price. It also assumes reinvestment of all
dividends as well as short- and long-term capital gain
distributions into the fund at the price at which each
distribution is made.
Compound Annual Return
The reported 6.21% 5-year return is the fund's compound
annual return (also called the average annual return). The
compound annual return is a calculated number that describes the
rate at which the investment has grown assuming uniform
year-over-year growth during the 5-year period.
A $10,000 investment in the Contrafund on December 31, 2000 has
grown to $13,515.34 on December 31, 2005. The ending value of
$13,515.34 = $10,000[(1 + 0.0621)^5] where 6.21% is the compound
annual return. The investment in the fund grew at an implied
annual growth rate of 6.21% over the 5-year period.
While total return and compound annual return are useful, they
do not tell how a particular mutual fund has performed compared
to its peers. They also do not provide information on the return
actually earned by investors after accounting for taxes.
Finally, they do not offer insight on how well the fund manager
has managed risk while achieving the returns.
Relative Return
Relative return compares the performance of a mutual fund
against its peers. It is the difference between the total return
of the fund and the total return of an appropriate benchmark
over the same period.
Fidelity Contra is a large-cap growth fund that primarily
invests in U.S.-based companies. It is therefore appropriate to
compare its performance with that of an average large-cap growth
fund. It is also relevant to benchmark the fund against the
Standard & Poor's (S&P) 500 index, comprising of large
U.S.-based companies.
While Fidelity Contra has a compound annual return of 6.21% for
the 5-year period ending December 31, 2005, Morningstar reports
the average large-cap growth fund has an average annual loss of
8.48% over the same period. The S&P 500 index has an average
annual return of 0.54% over the same period. Fidelity Contra has
outperformed with a relative return of 14.69% over the average
large-cap growth fund and with a relative return of 5.67% over
an S&P 500 index fund.
After-Tax Return
Unlike assets held in qualified accounts such as 401k plans or
individual retirement accounts (IRA), assets held in regular
individual or joint accounts are not tax-deferred. For such
non-qualified accounts, after-tax return is the return
realized after accounting for taxes.
Short-term capital gains and short-term capital gain
distributions from a mutual fund are currently taxed at the same
rate as earned income. Dividends, long-term capital gain
distributions and long-term capital gains realized from the sale
of fund shares are currently taxed at a lower rate.
Fidelity states the compound annual return for Fidelity Contra
before taxes is 6.21% for the 5-year period ending on December
31, 2005. When all distributions are taxed at the respective
maximum possible federal income-tax rate, the after-tax return
dips to 6.10%. The after-tax return drops further to 5.33% after
accounting for the long-term capital gain tax due on sale of the
fund shares.
Risk-Adjusted Return
Some fund managers take more risk than others. It is important
to assess a fund's return in light of the amount of risk the
fund manager takes to deliver that return.
Risk-Adjusted Return is commonly measured using the
Sharpe Ratio. The ratio is calculated using the formula (mutual
fund return - risk free return)/standard deviation of mutual
fund return. The higher the Sharpe ratio, the better is the
fund's return per unit risk.
Based on returns for the 3-year period ending on November 30,
2005, Morningstar reports Fidelity Contra's Sharpe ratio as
1.74. The fund's Sharpe Ratio may be compared with those of
similar funds to determine how the fund's risk-adjusted return
compares with those of its peers.
Beyond Mutual Funds
Return concepts such as relative return, after-tax return, and
risk-adjusted return may also be used for evaluating
separately-managed accounts, hedge funds and investment
newsletter model portfolios.
The AlphaProfit Sector
Investors' Newsletter, for example, tracks the total return
and compounded annual return of its Core and Focus model portfolios. To
provide Subscribers with a more complete picture of model
portfolio returns, this newsletter also tracks the relative and risk-adjusted returns of the
model portfolios. The newsletter's model portfolios are constructed
and repositioned with a view to maximizing after-tax returns.
Summary
While total return and compound annual return are useful, they
do not provide a complete picture of a mutual fund's
performance. Metrics such as relative return and after-tax
return offer insights on the fund's relative performance and
tax-efficiency. Risk-adjusted returns enable investors to assess
how a fund's returns stack up when risk is factored in.