When investors start their mutual fund research, they often seek out a mutual fund's return rate and compare it to the average mutual fund return of other funds.
As you conduct your fund research, here are a few factors you should keep in mind for financial planning:
- Evaluate short-term versus long-term returns.
- Pick the right benchmark.
- Watch for fees.
- Monitor your investing behavior.
Evaluate short-term vs. long-term returns
Stocks are a high-volatility asset, says Todd Jones, chief investment officer for Gratus Capital, so mutual fund return rates in the short term can swing significantly depending on market action. However, over the long term, those return rates should become more stable.
When considering a mutual fund's long-term returns, a fund should have at least a three-year annualized return record, but five years or more is preferable.
"Short-term performance is statistically insignificant. It's impossible to distinguish between a manager's skill and luck," says Michael Rosen, chief investment officer for Angeles Investments.
Rosen adds that when reviewing track records, it's also important to recognize if the current management team is responsible for that track record. A fund may have a great track record, but if the portfolio management team has only been in charge for a short time, they're not the reason for the fund's return or the net asset value size.
Jones says an actively managed fund with a long track record also indicates an established investment strategy that can evolve to cope with different market environments. "For young funds, in particular, don't get attracted to the shiny return because that could be a flash in the pan," he says, noting that many times these fund managers are "trying to score the most return possible by taking the most risk, just to gather assets."
Pick the right benchmark
Whether buyers are interested in index-based or actively managed mutual funds, they need to make sure the benchmark reflects the strategy to get an understanding of the average mutual fund return rate versus a similar benchmark. That's true whether the fund invests in equities, fixed income or an alternative strategy.
Jones says for equities the main benchmarks are the S&P 500 (.SPX), the Russell 1000 Growth (.RLG) and the Russell 1000 Value (.RLV) for large-cap stocks, the S&P 600 (.SML) for midcap stocks and the Russell 2000 (.RUT) for small-cap stocks.
For fixed-income investments, the main benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index. When it comes to international investing, Jones says the MSCI All-Country World Ex-U.S. Index has a slightly higher allocation to emerging markets, while the MSCI EAFE (.MXEA) tilts more to the foreign developed markets.
These different benchmarks relate to different categories, such as large-cap, midcap, small-cap, international equities and fixed-income investments, he says.
Within categories, investors should look at styles. Some portfolio managers may have a growth tilt, while others may look to value. There are narrower, niche funds such as technology, health care, energy or a host of other themes. Certain styles will go in and out of favor, Rosen says, and styles that are currently in favor may outperform.
"Managers that that own those stocks are going to do really, really well. But, that's not necessarily indicative that they can outperform in the future," he says, adding that styles can go in and out of favor quickly, which is why professionals recommend that investors own a diversified portfolio.
Watch for fees
You can't control how a market performs, but you can control how much you pay to invest. Fees will eat into mutual fund returns.
Research firm Morningstar says fund fees have fallen over the years. The firm's research shows the asset-weighted average expense ratio of all U.S. open-end mutual funds and exchange-traded funds has been nearly cut in half over the past two decades, from 0.87% in 1999 to 0.45% in 2019.
The asset-weighted average expense ratio for actively managed funds was 0.66% in 2019. For passively managed funds, such as index funds, the rate was 0.13% in 2019.
To calculate a mutual fund's return rate, subtract the fees from the performance to see how the fund compared to its benchmark. You can also use an online mutual fund returns calculator to compare the real costs of different funds.
Rosen says a fund's size and style can influence the types of fees managers charge. Large-cap equity indexes with billions of dollars in assets under management will charge very little, while an actively managed small-cap fund trying to keep a smaller asset base to be nimble in its investing style will have a higher fee.
When it comes to fixed-income mutual funds, fees are critical, Jones says, because interest rates are very low. The Bloomberg Barclays Aggregate is showing a return of around 1.2%, so a fixed-income fund that invests in low-risk bonds with a fee of 0.5% is eating up almost half of the return, he says.
Monitor your investing behavior
Lastly, Rosen says investors can research the average return on mutual funds, but they should be mindful of their investing behavior. Rosen points to research by consulting firm Dalbar looking at the average returns of retail investors and equity mutual funds over the years that shows investors typically underperformed the market by close to five percentage points annually.
There are a few reasons why, but Rosen says "the vast majority of the underperformance that investors actually see is (because of) their own behavior; they typically tend to buy at the top and sell at the bottom. So this leads to persistent underperformance in a very significant way."
The best way to avoid missing out on financial gains is to take a long view, which means being mindful of fees and sticking with investments during the ups and downs of market cycles.
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