Mutual Fund Basics: Analyzing Mutual Fund Returns

Fidelity Contrafund Example

While total and compound annual returns are useful in analyzing mutual fund returns, discerning investors will delve deeper using a variety of metrics to get a more complete picture on mutual fund performance.

On December 16, 2005 a leading financial website reports the trailing 1-year and 5-year returns of Fidelity Contrafund (Nasdaq: FCNTX), a no-load mutual fund, as 19.01% and 6.97%, respectively. While the financial website provides useful pre-tax return information, there is more to mutual fund returns.

Is the performance of Fidelity Contrafund superior or inferior? How tax-efficient was Fidelity Contrafund in delivering these returns? Are the returns of Fidelity Contrafund commensurate with the risk its fund manager took?

Discerning mutual fund investors will want answers to such questions as they evaluate mutual fund returns. Before getting into the nitty-gritty of mutual fund returns, it is good to review what the data reported in the financial website actually mean.

Mutual Fund Total Return

Fidelity Contrafund's reported 19.01% 1-year return is this mutual fund's total return for the December 16, 2004 to December 15, 2005 period. In practical terms, $10,000 invested in Fidelity Contrafund on December 16, 2004, is worth $11,901 on December 15, 2005. Total return includes more than the appreciation (or depreciation) of the mutual fund's share price. It also assumes reinvestment of all dividends as well as short- and long-term capital gain distributions into the mutual fund at the price at which the distribution is made.

Mutual Fund Compound Annual Return

The reported 5-year return of 6.97% for the Fidelity Contrafund is the mutual fund's compound annual return. (The compound annual return is also called average annual return.) Compound annual return is a calculated number that describes the rate at which an investment has grown if it grew at a steady rate.

A $10,000 investment in Fidelity Contrafund on December 16, 2000 has grown to $14,005.87 on December 15, 2005. The ending value of $14,005.87=$10,000* [(1+0.0697)^5] where 6.97% is the compound annual return. The investment in Fidelity Contrafund grew at an implied growth rate of 6.97% over the 5-year period.

While total return and compound annual return are useful mutual fund performance metrics, they do not tell how a particular mutual fund has fared versus its peers. They also do not provide information on the return actually earned by investors after accounting for taxes. Finally, they do not offer insight on how well the mutual fund manager has managed risk while achieving the returns.

Mutual Fund Relative Return

Relative return helps in comparing the performance of a mutual fund against its peers. Relative return is the difference between the total return of a mutual fund and the total return of an appropriate benchmark over the same period.

Fidelity Contrafund is a large-cap growth mutual fund that primarily invests in U. S.-based companies. It is therefore appropriate to compare Fidelity Contra's performance with that of other large-cap growth mutual funds. It is also appropriate to benchmark Fidelity Contra against indexes like the Standard & Poor's 500 (S&P 500) which comprises of large U. S.-based companies.

While Fidelity Contrafund has a compound annual return of 6.97% for the 5-year period ending December 15, 2005, Morningstar reports the average large-cap growth mutual fund to have an average annual loss of 9.51%. The S&P 500 index has a compound annual return of just 0.61%. Fidelity Contrafund has outperformed both benchmarks with a relative return of 16.48% over its average large-cap growth mutual fund peer and a relative return of 6.36% over the S&P 500 index.

Mutual Fund After-Tax Return

Unlike return from assets held in qualified accounts such as 401k plans or individual retirement accounts, return from assets held in non-qualified individual or joint accounts are not tax-deferred. With non-qualified accounts, after-tax return is the return realized after accounting for taxes.

Short-term capital gains and short-term capital gain distributions received from the mutual fund are currently taxed at the same rate as earned income. Dividends, long-term capital gain distributions, and long-term capital gains realized from the sale of mutual fund shares are currently taxed at a lower rate.

Fidelity states the compound annual return for the Fidelity Contrafund before taxes is 4.01% for the trailing 5-year period ending September 30, 2005. When all distributions are taxed at the maximum possible federal tax rate, the after-tax return drops to 3.52%. The after-tax return drops further to 3.23% after accounting for the long-term capital gain tax due on sale of this mutual fund's shares.

Mutual Fund Risk-Adjusted Return

Some mutual funds take more risk than others. It is therefore important to evaluate mutual fund returns in the light of the amount of risk mutual fund managers take to deliver the return.

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

Based on returns for the 3-year period ending November 30, 2005, Morningstar reports Fidelity Contrafund's Sharpe Ratio as 1.74. Fidelity Contrafund's Sharpe Ratio may be compared with those of similar mutual funds to determine how Fidelity Contra's risk-adjusted return compares with those of its peers.

Beyond Mutual Funds

Return concepts such as relative return, after-tax return, and risk-adjusted return are useful in analyzing not only mutual funds but also separately-managed accounts, hedge funds, and investment newsletter model portfolios.

The AlphaProfit Sector Investors' Newsletter, for example, tracks the annual return and compound annual return of its Core and Focus model portfolios. To provide Subscribers with more complete picture on model portfolio returns, this investment newsletter also tracks the relative and risk-adjusted returns of the model portfolios. The investment newsletter's model portfolios are constructed and repositioned with a view to maximizing after-tax returns.

Summary

While total return and compound annual return provide useful information on mutual fund performance, they do not provide a complete picture. Metrics such as relative return and after-tax return can provide valuable insights on a mutual fund's relative performance and tax efficiency. By looking at risk-adjusted returns, investors can assess how a mutual fund's returns stack up when risk is factored in.

Sam Subramanian
AlphaProfit Investments, LLC
December 23, 2005

Sam Subramanian, PhD, MBA is Managing Principal of AlphaProfit Investments, LLC. He edits the AlphaProfit Sector Investors' Newsletter™. The investment newsletter is ranked #1 by Hulbert Financial Digest. As of November 30, 2005, the investment newsletter's model portfolios have gained up to 82.7% since start of publication on September 30, 2003. The Dow Jones Wilshire 5000 has gained 34.5% during the same period. To learn more about the investment newsletter, visit http://www.alphaprofit.com.

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