Evaluating Mutual Fund
Performance
Four important factors in analyzing fund performance:
1. Returns
2. Investment Style and Risk
3. Portfolio Composition
4. Turnover and Taxes
Examining these factors reflects how a fund performed in
the past. Past performance may not guarantee future
performance.
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Returns
•Returns can be generated through:
1. Dividend Distributions
2. Capital Gains Distributions
3. NAV through unrealized Capital Gains
•The importance of each component varies with the type
of fund.
•Growth, Capital Appreciation, Foreign funds - realized
and unrealized Capital gains;
•Bond fund, Equity Income fund - Dividend and income2
Returns
Returns can be generated through:
1. Dividend Distributions
2. Capital Gains Distributions
3. NAV through unrealized Capital Gains
3
Returns - Dividends
• Dividends - also called investment income, has two
sources:
1. Cash dividends paid stocks (quarterly)
2. Interest payments made by bonds and other
fixed income securities (Quarterly or semiannually).
• Fund distributes income according to its own
distribution schedule (monthly, quarterly,….).
• Elect to receive cash or reinvest in the fund at its NAV
4
Returns - Dividends
• Undistributed dividends are placed in a money market
fund (Cash like securities) until regularly scheduled
payout date.
• Ex-dividend Date : On the day the fund distributes its
income, NAV per share declines by the amount of cash
payout. The date on which the NAV is reduced is called
Ex-dividend date. Board sets the ex-dividend date.
5
Returns - Capital Gains
• NAV can be affected by
1. Realized Capital Gains;
2. Unrealized Capital Gains.
• Realized Gains are any capital gains on securities that a
manager has sold out of the fund’s portfolio.
• Tax law permits capital gains to be distributed once a
year. During the year, fund keeps track of realized capital
gains and losses.
• Net Capital Gains are distributed.
• Elect to reinvest net capital gains, usually at POP.
6
Returns - Capital Gains
• Unrealized Gains are fund’s paper profits. As market
price of securities rises, the NAV per share also increases.
• Any unrealized losses are also reflected on fund’s NAV.
• Therefore, total return from a mutual fund for a given
year is determined by the dividend distributions, net
capital gains distributions, and NAV due to unrealized
capital gains.
7
Total Return
• Total return is computed for a given period of time, such
as YTD, 1- year, 3-years, 5-years, 10-years, etc., as
mandated by SEC.
•Total Return = ENAV-BNAV+DIST+DIV
BNAV
– ENAV = NAV at the end of period;
– BNAV = NAV at the beginning of period;
– DIST = capital gains distributions during the period;
– DIV = dividend income during the period.
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Total Return
• Based on Washington Mutual Investors Fund’s NAV
(Fig. 5.3):
•Total Return = $32.91-$30.35+$2.6+$0.61 = 19.01%
$30.35
•Annualized Total Return
•Average Annualized Total Return
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Total Return
• Discrepancy in computing Average Annualized Total
Return:
• Fig. 5.3- 1996, 1997, 1998 returns are 20.16%, 33.29%
and 19.37%, respectively. Therefore,
–Average Annualized Total Return:
•(20.16+ 33.29+19.37)/3 = 24.28%, but in
Fig 5.1, 3-year average is 22.9%
10
Total Return and Cost
• On-going expenses such as management fees, custodial
fees, directors’ fees, 12b-1 fees) are deducted each day
when fund computes NAV. Therefore, total return factors
in on going expenses.
• Sales load (back end or front end) and redemption fees
are not factored in. Known as load-adjusted total return.
It is less than total return. Not widely publicized.
• SEC regulations mandate the formulas to be used as
well as how the information must be presented.
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Total Return and Cost
• On-going expenses such as management fees, custodial
fees, directors’ fees, 12b-1 fees) are deducted each day
when fund computes NAV. Therefore, total return factors
in on going expenses.
• Sales load (back end or front end) and redemption fees
are not factored in. Known as load-adjusted total return.
It is less than total return. Not widely publicized.
• SEC regulations mandate the formulas to be used as
well as how the information must be presented.
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Evaluating Total Return
• Analyze Total Return by:
1. Reviewing the return over 3 or more years; how it has
performed during various bull and bear market cycles.
2. Comparing returns with those of its peers over the same
periods;
3. Comparing return to an appropriate benchmark.
•Review Morningstar Mutual Fund Report
•Review Value Line Mutual Fund Report
13
Investment Style and Risk
• Large diversified fund protects investors against a
decrease in the price of a single security.
• Mutual funds do not protects their investors against
market or systematic risk.
• Risks associated with a mutual fund are determined by:
1. Fund’s investment objective;
2. Portfolio manger’s investment style.
14
Investment Style and Risk
•What is Investment Style?
–On what basis does the manger choose the securities;
– How does the fund manager analyze the securities.
• Three primary types of investment style
1. Value
2. Growth
3. Momentum.
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Investment Style - Value
•Value Investing
– Invest in companies whose current market value appears to be
below the company’s real worth;
–stock is below the value of comparable companies in the same
business;
• Manger utilize fundamental analysis to assess value;
valuation techniques of the flowing type is often used:
– Price/ Earnings approach
– Price/ Book Value approach
–Dividend Growth approach
16
Investment Style - Growth
• Growth Investing
– Portfolio manager selects company based on expectation of
strong growth;
– underlying belief is that if a company’s earnings growth
meets or exceeds analysts’ expectations, the stock price will
appreciate.
• Earnings announcements and price volatility:
– Stock price volatility is high during the period leading up to
quarterly earnings announcements;
– This volatility reflects the price movement of a growth fund;
can be a Manger utilize fundamental analysis to assess value;
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Investment Style - Growth
• Two earnings figures that determine the markets’ and
managers’ reactions:
–1. Earnings figure published by analysts. Usually more
conservative number with build in contingencies surrounding
the company and sector;
–2. Whisper number. Amount analysts expect if all
contingencies are realistically priced.
• If the reported earnings exceeds expectations, price will
increase, and vice versa.
• If earnings growth is projected to slow down, price will
fall.
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Investment Style Growth/Value
• GARP - Growth at a Reasonable Price. A conservative
approach that is a combination of growth and value
styles.
– Primary method is : Price- to -Sales per share approach.
• Fundamental valuation techniques may not be
applicable for such companies.
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Investment Style -Momentum
Investing
• Momentum Investing:
–Portfolio manager believes that the market value of the stock
will increase rapidly;
–Ignores value measures when selecting stocks; stocks may be
overvalued or undervalued;
– As long as there are strong ‘buy’ recommendations, sales and
earnings continue to grow, exceeding expectations, stock price
will continue to rise;
– Style resembles ‘herd mentality’.
•This style is not in favor now.
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Investment Style -Other
Considerations
• Other Considerations:
–Socially Responsible Investing:
•Green Funds - focuses on Environmental Issues;
•Fund may not invest in companies that exploits workers in
foreign countries - case of South Africa.
–Investing based on Insider trading:
• Follow the smart Money:
• Portfolio manager tracks the trading patter of senior
executives and other insiders in the company;
• Their activities are reported to the SEC- public
knowledge.
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Other Risk Considerations
• For Foreign and Global Funds:
– Currency Risk
– Country Risk
•For Bond Funds
– Bond Quality
– Interest Rate Risk
22
Turnover and Taxes
• Turnover measures how often the total holding is changed.
• 100% turnover - holding is changed once a year;
• 300% turnover - holding is changed three times a year;
• Low turnover is characteristic of a ‘Buy-hold’ policy;
–Large Cap, Value investing, Bond fund etc.,
• High turnover indicative of active trading strategy:
–Aggressive growth, Capital appreciation, momentum trading
•High turnover creates higher transaction cost. Return must
reflect this added cost.
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Turnover and Taxes
•High turnover is not always bad. Turnover should be
judged against the objective of the fund.
• Investors may equate high turnover with market
savvy and intelligence of the fund manager.
• When market performs well, investors ignore
turnover and other cost associated with it. When
market is flat or performing poorly, this cost stands
out.
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Turnover and Taxes
•High turnover will result in higher realized capital
gains (losses);
•Capital gains must be distributed the year it is
realized; investors may be presented with a high tax
liability;
• Distributed capital gains qualifies for short term or
long term gains depending on the length of holding;
• A fund manager,with an eye toward tax efficiency,
may minimize capital gains by lowering turnover. 25