Mutual Fund Returns

Historic mutual fund returns are the first thing most of us look at when comparing mutual funds, and for good reason...that's what we're looking for. But not all returns are created equally, so the first thing you must do is determine how a particular source has calculated returns.

Mutual fund returns can be total returns, which would include the dividend yield, or they could be net of the dividend yield. Most are net of fees other than loads and redemption fees. All are net of the funds' trading costs. Other expenses may or may not be included. And there are two ways of computing average returns: the arithmetic mean and the geometric mean.

Load mutual funds add a bit of difficulty to calculating returns. See Special Considerations with Load Mutual Funds at the bottom of this page.

Yield, fees and expenses are something you'll have to figure out on your own on a case-by-case basis. But remember, if you want to know the real deal and compare apples to apples, all of the costs that will diminish your mutual fund returns must be deducted from the end-of-period NAV (net asset value, i.e., share price) before computing the periodic return.

Annual mutual fund returns should always be calculated with NAVs plus distributions. This ensures that the components of the expense ratio (management, advisor and 12b1 fees) have been deducted, but it does not take into consideration the effects of front-end loads, back-end loads or redemption fees. If you stick with no load mutual funds, those additional costs won't be an issue. The calculation of annual returns is described in detail on a separate page.

Average mutual fund returns can be computed as an arithmetic mean or a geometric mean, and there are reasons for using both. You should expect the geometric mean to be less than the arithmetic mean, it's just the way the math works.

We covered the arithmetic mean in the Mean & Standard Deviation subsection. It's simply the arithmetic average. The arithmetic mean of annual returns is usually what you see listed as a mutual fund's average annual return. It will tell you how well a fund performed over any particular period of time and is the correct measure for this purpose. But it won't tell you how well you would have done if you were invested in the fund over that same period. For that you need the geometric mean.

The geometric mean works like the basic compound return formula [(1 + r)ⁿ] except r will vary from year to year or whatever period you are using. The calculation of the geometric mean for a three year period would be done as follows:

r = [(1 + r₁)(1 + r₂)(1+ r₃)]^1/3 - 1

If the returns for three consecutive years were 12%, -8% and 15% the holding period return would be

r = [(1 + r₁)(1 + r₂)(1 + r₃)] - 1
r = [(1 + 0.12)(1 - 0.08)(1 + 0.15)] - 1
r = [(1.12)(0.92)(1.15)] - 1 = 1.185 - 1
r = 0.185 = 18.5%

the geometric mean for the three years would be

r = [(1.12)(0.92)(1.15)]^1/3 - 1
r = (1.185)^1/3 - 1 = 1.0582 - 1
r = 0.0582 = 5.82% per year

and the holding period return can be calculated from the geometric mean

r = (1 + 0.0582)³ - 1 = (1.0582)³ - 1 = 0.185 = 18.5%

This also works over a number of periods. The S&P 500 index started 1997 at 740.74 and closed at 1418.30 at the end of 2006. The compound annual return on the index can be computed as follows:

r = (1418.30 ÷ 740.74)^1/10 - 1 = (1.9147)^0.10 - 1
r = 1.0671 - 1 = 0.0671 = 6.71%

If you compounded all of the annual returns for that period, you'd get the same result. This also works on a monthly basis, but you'd have 120 periods and have to take the 120th root to get the same result. Here's what the 10 years looks like:

You can do this with the TVM functions on your financial calculator, but it's a whole lot easier to learn how to do the math, plus you'll gain a better understanding of how it works. Take time now to make sure you understand how the geometric mean is calculated and how it's used to compute mutual fund returns and for other investing computations, it's a very important concept.

Yield is a component of total return that varies in significance depending on the type of mutual fund you're evaluating. Dividend yield on a diversified stock fund will be fairly low and the dividend yields on small-cap growth funds and technology funds are apt to be nearly insignificant. On the other hand, the yield on growth and income funds, bond funds and real estate funds will be quite significant. As noted above, the published rate of return may or may not include the yield, so you may need to do some arithmetic to determine if it is included, which would make the return the total return.

Yield is a parameter that definitely needs to be evaluated on a relative basis within a fund's category, as yields will vary markedly from category to category, as will their effects on mutual fund returns.

As yields give rise to taxable events and are taxed as ordinary income, it's best to keep high-yield mutual funds in tax deferred accounts unless you are holding the funds for the purpose of providing a stream of income. Even if you elect to automatically reinvest all of your distributions, a tax liability will be incurred on the yield from any fund, other than a tax-exempt municipal bond fund, held in a taxable account.

On the bright side, high-yield stock funds provide a buffer to downturns in the stock markets, as their yields tend to buoy mutual fund returns.

Risk-adjusted returns are a pseudo measure of risk-to-return, as such they form an intuitive bridge between return and risk and risk-to-return. But, as they are another way of expressing returns, it seemed appropriate to discuss them in this section.

Risk-adjusted returns are always subject to scrutiny, as they are not always calculated in the same manner. In my humble opinion, risk-adjusted returns should be calculated by dividing mutual fund returns by standard deviation then multiplying by a relevant benchmark's standard deviation. This will give you returns that are relative to the benchmark on a risk-to-return basis.

Here's an example of risk adjustment: The large-cap growth fund used earlier as an example has a 10-year average return of 13.4% and a standard deviation of 23.9%. A broad market index had a return of 8.3% and standard deviation of 18.5% for the same 10 year period. The risk-adjusted rate of return of 10.4% for the growth fund is calculated as follows:

[r_fund ÷ s_fund] s_market = [13.4% ÷ 23.9%] 18.5% = 10.4%

10.4% vs 8.3% for the market index

    Where r = rate of return and s = standard deviation

In this example, the growth fund beat the broad market index by 2.1 percentage points, or 25.3%, on a risk-adjusted basis.

You'll find more on risk in the next subsection, Mutual Fund Risk.

Special Considerations with Load Mutual Funds

Back-end loads are trickier, as they are paid at the time you sell your shares and you probably don't know exactly when you'll sell your shares. So the best thing to do is take a conservative approach and deduct the back-end load from the NAV at the end of the most recent period for which you are calculating your return. Now, don't get carried away and take it out and leave it out each year. If you deducted it when you calculated your return last year, this year you need to recalculate last year's return without deducting the load and deduct the load from this year's NAV.

Funds with contingent deferred sales loads (CDSLs) are a bit easier, as the load goes away after a fixed number of years. If you plan on holding these funds long enough for the load to disappear, then you can calculate your returns the same way you would if they were no load funds. If you know you're going to sell before the fixed period ends or you're not sure and you want to be conservative, you should calculate your returns using the same method used for back-end load funds. If the load decreases each year, which is likely with a CDSL, you'll have to remember to adjust your calculations accordingly.

Whether you're evaluating load or no load mutual funds, mutual fund returns should be one of your first considerations but never your sole consideration. Mutual fund returns should always be compared on a relative basis, preferably on a risk-adjusted basis.

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Move on to the next subsection, Mutual Fund Risk.