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02.22.06
How To Dissect Mutual Fund Returns
 By
Sam Subramanian
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 the S&P 500 index.
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.
Read
the rest of the article.
About the Author:
Sam Subramanian, Ph.D, MBA is Managing Principal of AlphaProfit
Investments, LLC. He edits the AlphaProfit Sector Investors’ Newsletter™.
The investment newsletter is ranked
#1 by Hulbert Financial Digest. As of December 31, 2005, the investment newsletter’s
model portfolios have gained up to 87.8% since start of publication on September
30, 2003. The Dow Jones Wilshire 5000 index has gained 34.6% during the same period.
To learn more about the newsletter, visit http://www.alphaprofit.com
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