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Your Fund Is Better Than You Think
Two common errors investors make in evaluating their funds
 At
the beginning of every year, as investors examine their year-end statements
from their mutual fund company(s), we typically get questions regarding fund
performance that cluster around two common mistakes in calculating fund returns.
The questions usually spring from the perception that one or more of their
mutual fund holdings are not performing well. In many cases, however, the
problem is not that the funds are performing poorly, but rather that investors
are misinterpreting the information about these funds that is presented on
their statements.
Before we talk about those mistakes, however, let's revisit the key
measure of an investment security's performance: total return. This
will be important to keep in mind for later in the article.
Total Return Is the Key
The total return for a security has three components:
- First is the change in the market price of the security. If prices go
up, it's called "capital appreciation." If prices go down,
it is called "capital depreciation." This is also often called
the price return. This is what most investors typically think of when they
think of total return, but it's not the complete picture.
- Second is the security's "income," or "yield." Basically,
this is either the interest from fixed-income securities or the dividends
from equity investments.
- Third, and often overlooked, is the return from the "reinvestment" of
a security's income (mutual funds also distribute realized capital
gains which must be "reinvested," as well). This income can either
be reinvested into the same security (the most common assumption) or into
other securities, including of course cash. This third component is often
referred to as the "magic" of "compounding" in long-term
returns.
While it seems fairly obvious that income, and its reinvestment, make up
the majority of long-term, fixed- income security returns, you may be surprised
to learn that depending on the time frame examined, they actually make up
roughly half of the long-term return of stocks as well.
For example, even over the past 20 years (1988-2007) which featured the
outsized price gains of the 1990s, dividends and their reinvestment made
up roughly 40% of the total return of the S&P 500. The return from price
appreciation alone was 494%, but the total return with reinvested dividends
was 802%!
With an understanding of total return as the proper measure of fund performance,
let's examine why investors often miss that mark when using either
NAVs or cost basis to determine how their funds are doing.
Net Asset Values (NAVs) Can Be Misleading
NAV (short for "net asset value) is a mutual fund's price per
share. It is calculated by dividing the total value of all the securities
in its portfolio (less any liabilities) by the number of fund shares outstanding.
It is typically computed once a day based on the closing market prices of
the securities in its portfolio. Every client who buys or sells the mutual
fund that day gets the same price (NAV).
Many investors look at the changes in the NAVs (prices) of their mutual
funds to calculate their returns. However, this can lead to a misleading
picture of fund performance for two reasons. First, as you may recall from
the discussion above, simply looking at the price return for a security does
not capture the income generated from interest or dividends, which can be
a significant portion of the total return.
Second, in addition to paying out dividends and income, by law, mutual funds
must also distribute any realized capital gains on their holdings. When a
mutual fund makes a distribution, it comes right out of the NAV, reducing
it by the exact amount of the distribution (before any market action), so
when you just look at a fund's NAV you are not only missing dividends
and interest, but you may be missing part of your capital appreciation, as
well.
To see how this distorts the picture let's look at two examples.
First, let's look a simplified illustration for an equity fund. Let's
call it Equity Fund A. At the beginning of the year Equity Fund A's
NAV was $100. Over the course of the year, the fund collected $2 in dividend
yields and interest (on cash holdings), realized $8 in capital gains, and
had unrealized gains of an additional $10. In sum, Equity Fund A had a total
return of $20 ($2 + $8 + $10) and the NAV will now be $120. It had a total
return of 20%.
At the end of the year (when most mutual funds distribute gains), the fund
will have to distribute $10 (the income and realized gain). The NAV will
drop $10 after the distribution to $110. The fund didn't really lose
8.3% in one day ($10 distribution divided by $120 pre-distribution NAV).
That money was just distributed back to the investor who has the option of
either reinvesting the distribution in the fund or letting it go to cash.
An investor simply comparing the NAV of $110 at the end of the year to an
NAV of $100 at the beginning of they year, would calculate a return of just
10% instead of the actual return of 20%.
Now let's take a look at a bond fund. This is really where the NAV
problem can be particularly troublesome. Bond funds get most of their return
from interest, so they distribute nearly all their gains each year. This
can make them look like they are running in place, when they are actually
generating steady long-term returns. (Notice how many bond funds, even those
who have been around for a long time, still have NAVs close to their original
$10 offering price.)
In a simplified example, Fixed Income Fund B has a NAV at the beginning
of the year of $100. Let's say that over the year it collected $5 in
income, realized $1 in capital gains, and has $2 of unrealized losses on
the books. The NAV before distribution will be $104 ($5 + $1 -$2). The total
return for the year will be 4%.
The total distribution at year-end for Fixed Income Fund B will be $6 ($5
+ $1). The fund's NAV will now drop from $104 to $98. (In reality,
most fixed income funds have monthly or quarterly income distributions instead
of annual distributions, but with many aspects of these illustrations, we
are trying to keep it simple.) An investor simply looking at NAVs would think
they lost 2% on this fund instead of making 4%. Fixed income funds are often
victims of this sort of thinking.
Cost Basis Information – Pros and Cons
Most investor reports contain cost basis information. Indeed, for taxable
investors attempting to maximize after-tax total returns, this is extremely
critical information to have. That said, as with NAVs, trying to calculate
fund returns by comparing your cost basis to the current value of your
holdings can give misleading results.
The problem again is the distribution of gains. In this case though, it
isn't the reduction in NAV that is throwing investors, but how the
money is reinvested.
Let's go back to simplified example above using Equity Fund A. Let's
say an investor bought $100,000 of the fund at the beginning of the year
at an NAV of $100. That would mean that they bought 1000 shares of the fund.
At the end of the year, the fund distributed $10 of gains per share, which
means that the investor received $10,000. What happens to the cost basis
depends on how the distribution is re-invested. Let's say it is not
re-invested in the fund and is allowed to go directly to cash (which is the
preferred course of action for distributions in taxable accounts as it is
more tax efficient to re-balance the portfolio). In this case, the cost basis
will be $100,000 and the market value will be $110,000. This suggests a 10%
return when the fund really returned 20%.
It gets more complicated, however, when the returns are re-invested in the
mutual fund. Using the same example above, let's actually break out
the numbers. The investor received a $10,000 distribution from Equity Fund
A, which, when reinvested at the post distribution NAV of $110, yields 90.91
additional shares. The investor now owns 1090.90 shares at an NAV of $110/share.
In this case, the market value of the position is $120,000, which is what
you should expect given the gains over the course of the year.
However, since $10,000 worth of new shares were purchased, the cost basis
increases to $110,000. Compared to the market value of $120,000, that looks
like a gain of $10,000 on a base of $100,000 or a 9% return. Again, the actual
return was 20%!
This same problem holds for bond funds as well, but (at last) I'll
spare you the math!
Why Does This Have To Be Confusing?
So why is it so common to just list just the cost basis and the market value
of your mutual funds on your reports? Why don't companies show you
how each fund has performed on a total return basis?
Well, a big reason is that a "total return since purchase" figure
can be very misleading because it lacks context. For instance, one of your
funds might show a 10% total return since purchase, while another may show
a 5% loss. And yet, if they were bought at quite different times, the second
fund could actually have been the better performer!
Let's say that since the first fund was purchased, similar funds were
up 15%. That 10% return doesn't look so good now, does it? As for the
second fund, let's say that similar funds lost 10% during the time
you have owned it. Now, it looks like it has performed relatively well. In
the end, it's important to remember that securities can be purchased
and sold every day, but security listings can only show a snapshot at the
end of a time period.
In the final analysis, while it may be difficult to get a fairly quick total
return of the individual underlying mutual fund holdings that is not where
your focus should be anyway. What you should be paying attention to is the
total return of your entire investment portfolio. Has it generated a satisfactory
rate of return given its appropriate risk levels? That is the key number
to judge.
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