How to Analyze Mutual Fund Performance

Don't Overlook Performance History When Buying Mutual Funds

mutual funds printed in newspaper
Learn how to analyze past fund performance and be a better investor. Photo: tovfla/E+/Getty Images

Past performance of a mutual fund may not be a guarantee of future results but if you know how to analyze fund performance—if you know what to look for and what to avoid—you can make better investment decisions, which can increase the odds that future performance will meet or exceed your expectations.

Apples to Apples: Compare Funds to Appropriate Benchmarks

The first piece of information to analyze with mutual fund performance is the fund's returns compared to an appropriate benchmark. For example, if you want to see how well your fund is performing, it's best to compare it to the average return for funds in the same category.

Suppose you were to look at your 401(k) statement and notice that one of your funds had a large decline in value, but the others have performed well in a given time frame. This is no indication that the declining fund should be removed from your portfolio. Look at mutual fund types and categories first, to understand whether other funds in the category have had similar performance.

You may also use an index for a benchmark. For example, if the fund is a large-cap stock fund, a good benchmark is the S&P 500. If the S&P 500 declined 10% during the period you are analyzing but your fund declined 8%, you might not have reason for concern over the performance of your fund.

Know When Good Fund Performance Can Be Bad

If you are investing in a mutual fund, especially a stock fund, you likely plan to hold it for at least three years. Making this assumption, there is rarely a need to look at time periods of less than three years. However, this is not to say that short-term returns of, say, one year, are irrelevant. In fact a one-year return for a mutual fund that is incredibly higher than that of other funds in its category can be a warning signal.

Yes, strong performance can be a negative indicator, for a few reasons: One reason is that an isolated year of unusually high returns is abnormal. Investing is a marathon, not a race; it should be boring, not exciting. Strong performance is not sustainable. Another reason to shy away from high short-term performance is that more assets are attracted to the fund.

A smaller amount of money is easier to manage than larger amounts. Think of a small boat that can easily navigate the shifting market waters. More investors mean more money, which makes for a larger boat to navigate. The fund that had a great year is not the same fund it once was, and it should not be expected to perform the same in the future.

In fact, large increases in assets can be quite damaging to a fund's prospects for future performance. This is why good fund managers close funds to future investors; they can't navigate the markets as easily with too much money to manage.

Understand and Consider Market and Economic Cycles

Talk to ten investment advisors and you'll likely get ten different answers about what time periods are most important to analyze to determine which fund is best from a performance perspective. Most will warn that short-term performance (one year or less) won't tell you much about how the fund will perform in the future. In fact, even the best mutual fund managers are expected to have at least one bad year out of three.

Actively-managed funds require managers to take calculated risks to outperform their benchmarks. Therefore, one year of poor performance may just indicate that the manager's stock or bond selections have not had time to achieve expected results.

Focus on the 5- and 10-year Periods for Mutual Fund Performance

Just as some fund managers are bound to have a bad year from time to time, fund managers are also bound to do better in certain economic environments, and hence extended time frames of up to three years, better than others.

For example, perhaps a fund manager has a solid conservative investment philosophy that leads to higher relative performance during poor economic conditions but lower relative performance in good economic conditions. The fund performance could look strong or weak now, but what may occur over the next two or three years?

Considering the fact that fund management styles come in and out of favor and the fact that market conditions are constantly changing, it is wise to judge a fund manager's skills, and hence a particular mutual fund's performance, by looking at time periods that span across differing economic environments.

For example, most economic cycles (a full cycle consisting of both recessionary and growth periods) are five to seven years in time duration. Over the course of most five- to seven-year periods, there is at least one year when the economy was weak or in recession, and stock markets responded negatively. And during that same five- to seven-year period there is likely at least four or five years where the economy and markets are positive. If you are analyzing a mutual fund and its five-year return ranks higher than most funds in its category, you have a fund worth exploring further.

Use Weights to Measure Fund Performance

Common time periods for mutual fund performance available to investors include the one-year, three-year, five-year and ten-year returns. If you were to give heavier weights (more emphasis) to the most relevant performance periods and lower weights (less emphasis) to the less relevant performance periods, your humble mutual fund guide suggests weighting the five-year heaviest, followed by the ten-year, then three-year and one-year last.

You could create your own evaluation system based upon percentage weights. Suppose you give a 40% weight to the five-year period, a 30% weight to the ten-year period, a 20% weight to the three-year period and a 10% weight to the one-year period. You can then multiply the percentage weights by each corresponding return for the given time periods and average the totals. You can then compare funds to each other. The simple way is to use one of the best mutual fund research sites and do your search based upon 5-year returns, and then look at the other returns once you've found some with good potential. This weighting and/or search method assures that you will choose the best funds based upon performance that gives strong clues about future performance.

Don't Forget About Manager Tenure

Manager tenure must be analyzed simultaneously with fund performance. Keep in mind that a strong five-year return, for example, means nothing if the fund manager has been at the helm for only one year. Similarly, if the ten-year annualized returns are below average, compared to other funds in the category but the three-year performance looks good, you might consider that fund if the manager's tenure is approximately three years, because the current fund manager receives credit for the strong three-year returns but does not receive complete blame for the low 10-year returns. By putting all of the above factors together, you can make smart decisions about buying the best mutual funds for your portfolio.

Frequently Asked Questions (FAQs)

How can I compare many mutual funds at once?

Look around your brokerage for a mutual fund screener. These tools help investors quickly filter through funds according to their investing priorities. For example, if you want the cheapest large-cap stock fund, you could specify that you want large-cap equity funds, and you could sort your results by the expense ratio. You may have to check the fund's page to learn about manager tenure, but information such as annualized returns, expense fees, and dividend rates are easily found with a screener.

How do you compare mutual funds to ETFs?

Comparing mutual funds to ETFs will use many of the same methods you use when comparing mutual funds to other mutual funds. Expense ratios, manager tenure, and annualized returns will all apply to ETFs as they do to mutual funds. One additional consideration with ETFs is the tax situation. The structure of ETFs gives you greater control over taxation, compared to mutual funds. These differences can be more pronounced with actively managed funds that could trigger capital gains taxes throughout the year.

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