Mutual Funds: Performance is Relative

Investment returns are difficult to assess in isolation.

What does it mean if an asset has an annual return of 10%? Is it good, bad, or average?

To answer that, results must always be placed in context to be of any informative value.

That brings us to relative performance. We looked at this concept a while back in Assessing Investment Returns.

For numbers to make sense, they always need to be compared to something relevant.

Historic Performance

Depending on the jurisdiction, funds may be required to present performance data for multiple periods. For example: year-to-date; 1 year; 3 years; 5 years; 10 years; since inception.

Do not be mesmerized by year-to-date or the latest one year returns. Anybody can experience success in the short-run.

Luck can play a big role. Also, management trickery can be used to make current year returns look good. We will look at common fund manipulations later.

Of course, luck and manipulation can go both ways. They can also hurt results.

When reviewing, you must go back farther in time than one year returns. The longer the return data, the less chance that luck or portfolio manipulations will distort true performance.

To illustrate throughout this post, we will use a fictional mutual fund, ABC Canadian Equity Small-Cap Fund (ABC). Let us assume ABC had returns of 12% for 1 year, 10% annually over 3 years, and 11% annually over 5 years.

In comparing historic results, that suggests a consistency in fund returns. Consistency tends to be useful, though right now we do not know if those level of returns are good or bad. But it is a start.

However, if ABC returned 45% over 1 year, but still 10% annually over 3 years and 11% annually over 5 years, it suggests potential issues. This is a large variability of returns between years. Not to mention that the 1 year results may skew the 3 and 5 year data.

You need to determine why there was this volatility. There could be many reasons for the high variance. Perhaps performance reflected changes in the economy or markets as a whole. It may suggest a modification in investment tactics or a change in fund management. Perhaps the fund moved to increase its portfolio risk over previous periods.

When there is a large change in returns, you need to determine why. There might be ramifications for future results.

Bear in mind that past performance is no guarantee of future returns.

Past performance may provide clues as to future results. But, on its own, it is no guarantee of continued success.

Risk-Adjusted Returns

In assessing fund returns, compare performance against the level of risk within the fund.

You can compare the fund performance against zero return, the rate of inflation, or the so-called risk-free rate of return (that is, the return on an investment that has no risk).

I think most of us can agree that it is important for investments to provide positive returns. More difficult is agreeing how much above that base level – 0% nominal or real rate or the risk-free rate of return – the excess return should be.

One tool is to compare the investment risk for the category of your fund to other asset classes or investment styles with similar risk-return profiles. Or to adjust your return expectations for different risk levels.

For example, I would expect over the mid to long-term, riskier equity funds should outperform money market funds or other low risk investments such as term deposits or treasury bills. Remember that as risk increases, so should the expected returns.

A fund of US government bonds should have less risk than a fund composed of bonds from developing countries or a fund with bonds from distressed companies. Because of the greater risk, I would expect the funds from the developing countries or distressed companies to have higher long-term returns than a US government bond fund. But higher short term volatility as well.

In general, the riskier the asset, the higher the expected return should. But what the exact risk premium should be is up to the individual investor.

ABC earned 11% annually over 5 years. Perhaps very low risk money market funds generated 3% annually over the same 5 years. For some investors the trade-off between equity risk and expected returns is warranted. Other investors will prefer the safety of the money market funds, rather than the potential extra return from the equity. Other investors may desire riskier assets such as venture capital to seek out even greater returns.

Comparing fund performance against assets of higher or lower risk gives some comfort as to the expected risk-return trade-off.

This has some use for analytical purposes, but it does not assist in choosing a specific fund to invest in. Not to mention that assessing risk premiums between different asset classes or subclasses can be difficult. A bit of an apples to oranges comparison.

What we want is apples to apples. For that, you need to look at a fund’s direct competition.

Peer Group Returns

In comparing funds for possible investment, historic returns within the fund alone do not mean much.

What does it really tell me to know in isolation that ABC had a 1 year return of 12% and a 5 year annual return of 11%?

Not a lot.

We can compare the risk-return of ABC to other assets. Perhaps the 5 year annual return for U.S. large cap stocks averaged 9%. Is that good relative to ABC’s performance? Some investors may say yes, others no. Some have no idea. Hard to tell because U.S. large cap stocks differ in many ways from ABC’s small cap Canadian holdings. Apples to oranges.

However, a fund’s peer group is made up of the funds with the same investment style. Apples to apples. From our example, all Canadian equity small-cap funds would be the appropriate peer group for ABC. Now we can start better assessing ABC’s performance.

If the average Canadian equity small-cap mutual fund had a 5 year 8% annual return, 11% from ABC appears strong.

Do not stop there though. Averages can often be misleading.

You should also look at the relative ranking of ABC within its peer group.

Perhaps 10% of the peer group had 5 year annual returns exceeding 20%. Another 20% had returns greater than 15%, and another 20% had returns higher than 12%.

ABC had better 5 year annual returns than the average for the entire peer group. But when looking within the peer group, at least half of the funds outperformed ABC over the 5 year period. Seeing that, I might want to consider the funds that exceeded 20% return over ABC.

When determining which funds to invest in, comparison to a fund’s peers is very important.

And like with historic returns, the longer the comparative periods, the better the analysis.

Benchmark Returns

Another excellent way to assess performance is to compare it against a benchmark return.

Benchmarks can be anything. However, in practice, broad indices are used that try to most closely reflect the investment style of the fund.

An appropriate benchmark for ABC might be the MSCI Canada Small Cap index. The MSCI index tracks smaller capitalized Canadian companies. This is preferable to the better known S&P/TSX Composite Index. Why? Because the TSX Composite Index is weighted by market capitalization, so it has a large-cap bias.

To the extent possible, always try to compare apples to apples with benchmarks. This is especially true for the many investors who compare their portfolios to the Dow Jones Industrial Average. A very popular index in the media, but it only tracks 30 extremely large U.S. listed companies. Most investors have portfolios of a much different composition.

For many funds, you do not need to create your own benchmark. The fund itself determines a benchmark for comparison and discloses the benchmark to investors.

Always check to ensure that a fund’s benchmark is truly representative of the fund’s investment style. In our example, comparing the performance of ABC to 90 day U.S. Treasury Bills or 30 year Euro bonds makes little sense.

There may also be a standard benchmark for the peer group within which your fund sits. That way it is easy to compare funds within a specific peer group to each other and the same benchmark.

A major problem with comparing fund performance to an index is that the fund has operating expenses. An index does not. The greater a fund’s total expense ratio, the larger the performance deficit versus the benchmark. As a result, funds start at an immediate disadvantage when trying to beat their benchmarks.

Consider an index fund that mirrors the S&P 500. To the extent that it can duplicate the index, the gross performance of the fund should match the performance of the S&P 500. Perhaps the gross returns for both were 10% last year. But the fund also has a 2.0% total expense ratio. So, on a net return basis, the index fund under-performed the benchmark by 20% (10% for the S&P 500 versus 8% net return for the index fund).

Another thing to watch with benchmarks is that the fund sticks with its chosen benchmark. Should the fund change its investment style, it may be appropriate to modify its benchmark. But if it changes its benchmark simply to hide under-performance or in trying to make itself look better, be wary.

Summary

Past performance is not an indication of future investment success.

It may show a consistency of performance, especially if you look at longer term results. And it may indicate potential problems or changes within a fund.

While historic returns have some value, you should compare a fund’s returns against other asset classes of differing risk. You want to ensure that the risk premium on your asset is reasonable given other potential investments.

Even more important, always compare a fund’s performance against its peers and relevant benchmarks.

In assessing peers, look at both absolute returns and the fund’s ranking within the peer group.

In reviewing against a benchmark, ensure the chosen benchmark is appropriate for the fund’s investment style.