Mutual Fund Performance

This is a very complex subject and a brief discussion on some issues will help us.

When some of us look in our mutual fund statements, it is a common experience to find that our mutual fund performance has not been as good as the "market". This even though we took the trouble to choose a fund after a fair amount of research based on past performance. The frustrating thing for many, if not most, is that were they to change funds, the new ones may be as bad or worse as the last. Why is this? Mutual fund performance is a very complicated subject but here is a brief discussion on some issues that should give you a better understanding.

The first thing to understand is that funds are packaged products and as such, have a "wrapper" that we need to pay for in return for the convenience of having others look after the actual research, buying and selling. In actively managed funds, this wrapper will consist of fund managers, research departments, marketing departments, back-offices and trading among other things as follows:

Internal expense ratios consist of salaries, bonuses, advertising fees and all of the rents, bills and other mundane expenses that a business has to pay. These expenses are seldom out of line except in special circumstances. Funds are brutally competitive and can't afford to be out of line. These ratios are typically in the 1% - 2% range.

Trading expenses are a major component of fund expenses and will be high for a fund that does a lot of trading (ie. has high turnover in fund lingo) and lower for one that doesn't. In an index fund, these expenses are a lot lower but still, they are a drag on relative performance. So all other things being equal, even the "cheapest" index fund is guaranteed to underperform the index it follows. For the average stock fund, these expenses add up to about 1%-2% too.

Load is another issue that will impact your fund returns--what you paid or are paying for it. Did you pay up front for it with a one-time fee (front-end load), are you going to pay when your sell (back-end load) or are you going to pay-as-you-go (level load)?

Note: so-called no load funds are not "free"--they may not have a front or back load but they do charge you a fixed or variable recurring periodic "fee" that is built-in to their cost structure and marketing strategy. After all, they're not social service organizations and need to make a profit to stay alive but you knew that, right?

Taxes are related to trading--the more the trading indulged in, the greater the likelihood of taxable gains and unfortunately, many fund managers may have an incentive to "lock in gains" by doing just that. Again, this problem does not apply to index funds which make minimal trades in order to track an index.

But there is a lot more to "performance" than expenses. One of the reasons we choose an actively managed fund is because we like the idea of someone being at the wheel, so to speak. When the markets are in free fall, it is a comforting thought and hopefully, the manager will be alert enough to stem losses. This is not a luxury available to index fund holders who have to be alert and take action themselves.

Then there is the issue of consistency--how closely the fund follows its stated objectives. For example, does a fund that labels itself "large cap growth" follow the large cap indexes closely or does it weave in and out of that graph? The latter can happen if the managers decide to take a brief foray into "small cap value" territory just because that particular sector is doing well currently. This is a bad sign.

For a lot of us, the best we can hope to do is manage our portfolios to conform to a predetermined mix of styles that history says has a good chance of taking us where we want to go. However, in order to maintain that strategy, we need all parties to fit as neatly as possible into their sectors. If they don't, our entire plan is thrown into chaos. For gold mutual funds and other stock funds, the best tool we have for this purpose is the Morningstar Style Boxwhich divides the markets into 9 different styles or boxes that represent large, medium and small capitalization stocks paired up with growth, value or blend styles of management, leading to labels like "small cap value", "mid cap blend", "large cap value" and so on.

We can monitor our funds by making sure that they continue to plot on their stated style box in the reporting from the company themselves or from Morningstar. We also need to pay close attention to any advertising that trumpets performance numbers because those may represent performance only during a specific period that just happened to be good for the fund. . Fortunately, the SEC makes it compulsory for funds to report their percentage returns annually for 1-year, 3-year, 5-year, 10-year periods and also since inception.

Having said this, a vast majority of mutual fund companies will and do infact outperform the "markets" on a regular basis and are doing a stellar job under the circumstances and if we do ours by monitoring our mutual fund performance, we will do as well for ourselves as millions of investors already have. While doing so, it is important to keep in mind that the "market" is not the same thing as your portfolio and neither should it be.