Analysis of Historical Performance of Mutual Funds
When purchasing mutual funds, you should not ignore the history of performance. You can become a better investor if you know how to analyze fund performance, and if you know what to look for and what to avoid, this can increase the likelihood that future performance will meet or exceed your expectations.
Comparing Funds to Appropriate Benchmarks
The first piece of information to analyze in a mutual fund’s performance is the fund’s returns compared to an appropriate benchmark. For example, if you want to know how your fund is performing, it’s best to compare it to the average return of funds in the same category.
You can also use a benchmark as a measure. For example, if the fund is a large-cap stock fund, a good benchmark is the S&P 500. If the S&P 500 declines by 10% during the period you are analyzing, but your fund declines by only 8%, you may not have a reason to worry about your fund’s performance.
Knowing When Fund Performance May Be Good
If you are investing in a mutual fund, especially a stock fund, you are likely planning to hold it for at least three years. Based on this assumption, there is rarely a need to look at time frames less than three years. However, this does not mean that short-term returns, such as a one-year return, are not important. In fact, a one-year return for a mutual fund can be incredibly high compared to other funds in the same category, serving as a warning sign.
Yes, strong performance can be a negative indicator for various reasons: one reason is that a year of extraordinary high returns is unusual. Investing is a marathon, not a sprint; it should be boring, not exciting. Strong performance is not sustainable. Another reason to steer clear of strong 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 navigate easily in changing market waters. More investors mean more money, making the boat larger to maneuver. The fund that had a great year is not the same fund it was before, and it should not expect to perform in the same way in the future.
In fact, significant increases in assets can be very detrimental to a fund’s chances of achieving future performance. This is why good fund managers close funds to future investors; because they cannot navigate the markets easily when they have too much money to manage.
Understanding and Considering Market and Economic Cycles
If you talk with ten investment advisors, you are likely to get ten different answers about the most important time frames for analyzing the fund and determining which fund is the best in terms of performance. Most will warn you that short-term performance (one year or less) will not tell you much about how the fund will perform in the future. In fact, even the best mutual fund managers expect to have at least one bad year out of three.
Funds that are actively managed require managers to take calculated risks to outperform their benchmarks. Therefore, one year of poor performance may indicate that the manager’s choices in stocks or bonds have not yet yielded the expected results.
Focusing on Five- and Ten-Year Periods for Mutual Fund Performance
Just as some fund managers are likely to have one bad year from time to time, fund managers are also likely to excel in certain economic environments, thus making extended time frames up to three years better than others.
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For example, a fund manager may have a strong conservative investment philosophy that leads to relatively better performance during poor economic conditions and relatively lower performance during good economic conditions. The fund’s performance may appear strong or weak now, but what could happen over the next two or three years?
As fund management styles come and go in popularity and as market conditions constantly change, it is wise to assess the fund manager’s skills, and thus the performance of their mutual fund, by looking at time periods that span different economic environments.
For instance, most economic cycles (a complete cycle consisting of periods of recession and growth) last five to seven years. During most five- to seven-year stretches, there is at least one year when the economy was weak or in recession, and stock markets responded negatively. During the same five- to seven-year period, there are likely to be at least four or five years where the economy and markets are positive. If you are analyzing a mutual fund and its returns over five years rank higher than most funds in the same category, you have a fund worth exploring further.
Using Weights to Measure Fund Performance
Common time periods for the performance of mutual funds available to investors include one-year, three-year, five-year, and ten-year returns. If you want to give greater weights (more emphasis) to the most relevant performance periods and lesser weights (less emphasis) to the less relevant performance periods, a modest mutual fund guide recommends giving the highest weight to the five-year period, followed by the ten-year period, then the three-year period, and finally the one-year period.
You can create your own evaluation system based on percentage weights. Let’s say you assign 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 relative weights by each return over the given time periods and calculate the average of the totals. You can then compare the funds against one another. The simple way is to use one of the top mutual fund search sites and search based on five-year returns, then consider the other returns once you find some funds with good potential. This weighting and/or search method ensures the selection of the best funds based on performance that provides strong indicators about future performance.
Don’t Forget the Manager’s Tenure
The manager’s tenure should be analyzed alongside the fund’s performance at the same time. Remember that a strong five-year return, for example, means nothing if the manager has only been in charge for one year. Similarly, if the ten-year annual returns were below average compared to other funds in the same category but the three-year performance looks good, you might consider this fund if the manager’s tenure is approximately three years, because the current manager gets credit for the strong three-year returns but bears no responsibility for the low ten-year returns. By integrating all the factors mentioned above, you can make smart decisions about acquiring the best mutual funds for your portfolio.
Frequently Asked Questions (FAQs)
How can I compare multiple mutual funds at once?
Look for a mutual fund screening tool with your broker. These tools help investors quickly filter funds based on their investment priorities. For instance, if you want to find the cheapest large-cap stock fund, you can specify that you want large-cap stock funds and sort the results by expense ratio. You may need to check the fund’s page to see the manager’s tenure, but information like annual returns, cost ratios, and dividend rates can be easily found with the screening tool.
How
How do mutual funds compare to ETFs?
Comparing mutual funds to ETFs will use many of the same methods you would in comparing mutual funds to each other. Cost ratios, manager tenure, and annual returns will apply to ETFs just as they do to mutual funds. ETFs stand out for their tax treatment. The ETF structure gives you more control over taxes compared to mutual funds. These differences can be more pronounced in the case of actively managed funds, which can lead to tax burdens on returns throughout the year.
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Source: https://www.thebalancemoney.com/how-to-analyze-mutual-fund-performance-2466455
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