How To Dissect Mutual Fund Returns

1 January 2006 reported a leading financial daily the subsequent 1-year and 5-year returns of Fidelity Contra Fund (Nasdaq: FCNTX), a no-load mutual fund, as 16.23% and 6.21% respectively. While the financial daily returns data are useful, there is more to mutual fund returns.

Does the performance of the fund superior or inferior?

How tax-efficient fund is in the realization of the returns?

Is the return of the fund, which represents 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's returns, it is good to understand what the data reported in the financial daily really mean.

Total Return

Fidelity Contra reported 16.23% 1-year return is the fund's total return for the December 31, 2004 to December 31, 2005 period. On a practical level, invested $ 10,000 in the fund on 31 December 2004 is worth $ 11,623 31 December 2005. The total return includes more than the increase (or decrease) in fund's share price. It also assumes reinvestment of all dividends and short-and long-term capital gain distributions to the Fund for the price that 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 in the 5-year period.

A $ 10,000 investment in the Contra Fund, 31 December 2000 has grown to $ 13,515.34 31 December 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 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 relative to its peers. They did not give information about returns actually earned by investors after accounting for taxes. Finally, they do not provide insight into how well the fund manager has managed risk while achieving the returns.

Relative return

Relative return compares the performance of a common fund against its peers. That is the difference between the total return of the fund and the total return of an appropriate benchmark over the same period.

Allegiance Contra is a large-cap growth fund that primarily invests in US-based companies. It is therefore appropriate to compare its performance with an average large-cap Growth Fund. It is also relevant to benchmark the fund against the Standard & Poor's (S & P) 500 index, composed of large US-based companies.

While Fidelity Contra has a compound annual rate 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. 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 with a relative yield of 5.67% over the S & P 500 index fund.

After-tax returns

Unlike assets in qualified accounts as 401K plans and individual retirement accounts (IRA), the assets in regular individual or joint accounts are not tax-deferred. For such non-qualified accounts, after-tax return on 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. Yield long-term capital gain distributions and long-term capital gains realized from the sale of fund shares are currently taxed at a lower rate.

Allegiance says the compound annual return for Fidelity Contra before taxes is 6.21% for the 5-year period ending on 31 December 2005. When all distributions are taxed at the respective maximum possible federal income-tax, after-tax yield dips to 6.10%. After-tax return falls further to 5.33% after accounting for the long-term capital gains tax on sale of fund shares.

Risk-adjusted return

Some fund managers take more risk than others. It is important to evaluate a fund returns based on the amount of risk the fund manager takes to deliver back.

Risk-adjusted return is usually measured by Sharpe Ratio. The ratio is calculated using the formula (mutual fund return - risk free return) / standard deviation of the mutual fund returns. The higher the Sharpe ratio, the better the fund's return per risk.

Based on reports to the 3-year period ending 30 November 2005, Morningstar reports Fidelity Contra's Sharpe ratio is 1.74. Fund's Sharpe Ratio may be compared with the same resources to determine how the fund's risk-adjusted return compares with those of peers.

Beyond Mutual Funds

Return concepts such as relative return, after-tax return and the risk-adjusted return may also be used for evaluating separately-managed accounts, hedge funds and investment newsletter model portfolios.

The Alpha Profit investors' Newsletter, for example, tracks the total return and compound annual return of its Core and Focus model portfolios. To provide subscribers with a more complete picture of model portfolio returns, this newsletter also tracks the relative and risk adjusted return of the model portfolios. Newsletter model portfolios are constructed and placed to maximize after-tax returns.

Summary

While total return and compound annual return are useful, they do not give a complete picture of a fund's performance. Parameters such as relative return and after-tax return offer insights into the fund's relative performance and tax efficiency. Risk-adjusted returns enable investors to assess how a fund's returns stack up when risk is included in.