Evaluating funds

Since mutual funds have different investment objectives, which impact the types of investments they make, and different risk profiles, which communicate the types of risk they take, the first step in choosing a new fund for your portfolio is to identify the category of fund you want to add. Then you can evaluate a number of funds in that category in relation to each other to identify the one that you think is the best choice for you. A traditional way to express this process is that you want to be able to compare apples to apples.

Evaluating funds in relation to each other generally includes looking at the following measures:

  • Return, which is the gain or loss in the value of the fund, or what you get back in relation to what you invested and which is a measure of the fund’s success in meeting the fund’s objectives, in comparison with other funds with the same objective
  • After-tax return, which is the gain or loss after the tax you owe on the return is paid, and specific tax-related policies
  • Cost, which includes the fees you pay for buying the fund, and other expenses of ownership particularly in relation to the after-tax return, such as management fees and redemption fees
  • Tenure and reputation of the fund manager
  • Yield, which reflects how much income per share the fund paid over the past 12 months as a percentage of its current NAV
  • Change in a fund’s net asset value (NAV), or share price, which indicates whether — and by how much — shares in the fund have gained or lost value

Measuring return

You can use return statistics to evaluate your investment in a particular fund or to compare the performance of two or more funds with similar objectives.

A fund’s total return is the amount your investment increases or decreases in value when all distributions are reinvested. Many people consider total return the most accurate measure of performance.

To compare the total returns of two or more funds, you use percent return, which is a fund’s total return divided by your initial investment. This information lets you compare different-sized investments on an equal footing.

To compare the performance of funds you’ve owned for different periods of time, you use annual percent return, which is percent return divided by the number of years you’ve owned the fund. This yearly average lets you make a meaningful comparison, for example, of your return on a fund you’ve owned for ten years and your return on a fund you’ve owned for three years.

While past performance can’t reliably predict future results, a fund with a long history of strong annualized return may be a wiser investment, according to many experts, than a fund with a strong one-year performance that has been in existence only a short time.

You might also want to check if a fund’s annualized return reflects similar results for each of the years in the period. A result based on one or two very strong years, combined with several lackluster years, may suggest the fund is volatile or that the investment style that produced such uneven results in the past may do so again in the future.

Real return

Remember, too, that the returns your fund reports are not adjusted for inflation. That means to find your real return you subtract the current inflation rate from the stated rate of return. For example, if a fund’s return is 11% and inflation is currently 3%, its real return is 8%.

In addition, if your investment earnings are taxable, your actual return will be less than the pretax return. In the United States, where funds must report both pretax and after-tax returns, the difference, on average, is 2.5% less after calculating the effect of income taxes.

Using benchmarks

By comparing total percent return to a benchmark, such as a stock, bond, or mutual fund index, you can examine a fund’s performance in relation to the performance of a comparable segment of the investment market or to similar funds. Each fund indicates in its prospectus the indexes it has identified as appropriate benchmarks for the fund.

For example, a large-company stock fund is typically compared with the performance of the S&P 500 Index for the same period. A small-cap fund uses the Russell 2000 Index as a benchmark.

For specialized funds, the fund will identify a more narrowly focused benchmark. You’re in a better position to evaluate the performance of a sector fund if you compare it to an index for that sector rather than to the broader S&P 500. In addition, Lipper and Morningstar Inc. — companies that evaluate mutual funds — provide a range of indexes that track specific categories of funds.

Risk vs. return

In evaluating fund performance, you may also want to consider the effects of risk on potential return. For example, certain capital appreciation or sector funds are likely to be more volatile than other funds because of the investment risks the manager may take to meet the fund’s objective. Increased volatility means the value of your fund holdings could rise or fall dramatically at any time. In contrast, capital preservation funds are less volatile than other funds because they take fewer risks. But they also generally provide more modest returns.


Copyright© 2018 Lightbulb Press


Additional Resources