1

Evaluating Mutual Fund Performance

Four important factors in analyzing fund performance:

1. Returns

2. Investment Style and Risk

3. Portfolio Composition

4. Turnover and Taxes

Examining these factors reflects how a fund performed in the past. Past performance may not guarantee future performance.

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Returns

•Returns can be generated through:

1. Dividend Distributions

2. Capital Gains Distributions

3. NAV through unrealized Capital Gains

•The importance of each component varies with the type

of fund.

•Growth, Capital Appreciation, Foreign funds - realized

and unrealized Capital gains;

•Bond fund, Equity Income fund - Dividend and income

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Returns

Returns can be generated through:

1. Dividend Distributions

2. Capital Gains Distributions

3. NAV through unrealized Capital Gains

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Returns - Dividends

• Dividends - also called investment income, has two sources:

1. Cash dividends paid stocks (quarterly)

2. Interest payments made by bonds and other fixed income securities (Quarterly or semi- annually).

• Fund distributes income according to its own distribution schedule (monthly, quarterly,….).• Elect to receive cash or reinvest in the fund at its NAV

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Returns - Dividends

• Undistributed dividends are placed in a money market fund (Cash like securities) until regularly scheduled payout date.

• Ex-dividend Date : On the day the fund distributes its income, NAV per share declines by the amount of cash payout. The date on which the NAV is reduced is called Ex-dividend date. Board sets the ex-dividend date.

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Returns - Capital Gains

• NAV can be affected by

1. Realized Capital Gains;

2. Unrealized Capital Gains.• Realized Gains are any capital gains on securities that a manager has sold out of the fund’s portfolio.• Tax law permits capital gains to be distributed once a year. During the year, fund keeps track of realized capital gains and losses. • Net Capital Gains are distributed. • Elect to reinvest net capital gains, usually at POP.

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Returns - Capital Gains

• Unrealized Gains are fund’s paper profits. As market

price of securities rises, the NAV per share also increases.

• Any unrealized losses are also reflected on fund’s NAV.

• Therefore, total return from a mutual fund for a given year is determined by the dividend distributions, net capital gains distributions, and NAV due to unrealized capital gains.

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Total Return

• Total return is computed for a given period of time, such

as YTD, 1- year, 3-years, 5-years, 10-years, etc., as

mandated by SEC.

•Total Return = ENAV-BNAV+DIST+DIV

BNAV

– ENAV = NAV at the end of period;– BNAV = NAV at the beginning of period;– DIST = capital gains distributions during the period;– DIV = dividend income during the period.

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Total Return

• Based on Washington Mutual Investors Fund’s NAV

(Fig. 5.3):

•Total Return = $32.91-$30.35+$2.6+$0.61 = 19.01%

$30.35

•Annualized Total Return

•Average Annualized Total Return

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Total Return

• Discrepancy in computing Average Annualized Total

Return:

• Fig. 5.3- 1996, 1997, 1998 returns are 20.16%, 33.29%

and 19.37%, respectively. Therefore,

–Average Annualized Total Return:

•(20.16+ 33.29+19.37)/3 = 24.28%, but in

Fig 5.1, 3-year average is 22.9%

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Total Return and Cost

• On-going expenses such as management fees, custodial

fees, directors’ fees, 12b-1 fees) are deducted each day

when fund computes NAV. Therefore, total return factors

in on going expenses.

• Sales load (back end or front end) and redemption fees

are not factored in. Known as load-adjusted total return.

It is less than total return. Not widely publicized.

• SEC regulations mandate the formulas to be used as

well as how the information must be presented.

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Total Return and Cost

• On-going expenses such as management fees, custodial

fees, directors’ fees, 12b-1 fees) are deducted each day

when fund computes NAV. Therefore, total return factors

in on going expenses.

• Sales load (back end or front end) and redemption fees

are not factored in. Known as load-adjusted total return.

It is less than total return. Not widely publicized.

• SEC regulations mandate the formulas to be used as

well as how the information must be presented.

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Evaluating Total Return

• Analyze Total Return by:

1. Reviewing the return over 3 or more years; how it has

performed during various bull and bear market cycles.

2. Comparing returns with those of its peers over the same

periods;

3. Comparing return to an appropriate benchmark.

•Review Morningstar Mutual Fund Report

•Review Value Line Mutual Fund Report

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Investment Style and Risk

• Large diversified fund protects investors against a

decrease in the price of a single security.

• Mutual funds do not protects their investors against

market or systematic risk.

• Risks associated with a mutual fund are determined by:

1. Fund’s investment objective;

2. Portfolio manger’s investment style.

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Investment Style and Risk

•What is Investment Style?

–On what basis does the manger choose the securities;

– How does the fund manager analyze the securities.

• Three primary types of investment style

1. Value

2. Growth

3. Momentum.

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Investment Style - Value

•Value Investing

– Invest in companies whose current market value appears to be

below the company’s real worth;

–stock is below the value of comparable companies in the same

business;

• Manger utilize fundamental analysis to assess value;

valuation techniques of the flowing type is often used:

– Price/ Earnings approach

– Price/ Book Value approach

–Dividend Growth approach

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Investment Style - Growth• Growth Investing

– Portfolio manager selects company based on expectation of

strong growth;

– underlying belief is that if a company’s earnings growth meets or exceeds analysts’ expectations, the stock price will appreciate.

• Earnings announcements and price volatility:– Stock price volatility is high during the period leading up to quarterly earnings announcements;

– This volatility reflects the price movement of a growth fund; can be a Manger utilize fundamental analysis to assess value;

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Investment Style - Growth• Two earnings figures that determine the markets’ and

managers’ reactions:

–1. Earnings figure published by analysts. Usually more

conservative number with build in contingencies surrounding

the company and sector;

–2. Whisper number. Amount analysts expect if all

contingencies are realistically priced.

• If the reported earnings exceeds expectations, price will increase, and vice versa.• If earnings growth is projected to slow down, price will fall.

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Investment Style - Growth/Value

• GARP - Growth at a Reasonable Price. A conservative

approach that is a combination of growth and value

styles.

– Primary method is : Price- to -Sales per share approach.

• Fundamental valuation techniques may not be

applicable for such companies.

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Investment Style -Momentum Investing

• Momentum Investing:

–Portfolio manager believes that the market value of the stock

will increase rapidly;

–Ignores value measures when selecting stocks; stocks may be

overvalued or undervalued;

– As long as there are strong ‘buy’ recommendations, sales and

earnings continue to grow, exceeding expectations, stock price

will continue to rise;

– Style resembles ‘herd mentality’.

•This style is not in favor now.

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Investment Style -Other Considerations

• Other Considerations:

–Socially Responsible Investing:

•Green Funds - focuses on Environmental Issues;•Fund may not invest in companies that exploits workers in foreign countries - case of South Africa.

–Investing based on Insider trading:

• Follow the smart Money:

• Portfolio manager tracks the trading patter of senior executives and other insiders in the company;

• Their activities are reported to the SEC- public knowledge.

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Other Risk Considerations

• For Foreign and Global Funds:

– Currency Risk

– Country Risk

•For Bond Funds

– Bond Quality

– Interest Rate Risk

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Turnover and Taxes• Turnover measures how often the total holding is changed.

• 100% turnover - holding is changed once a year;• 300% turnover - holding is changed three times a year;

• Low turnover is characteristic of a ‘Buy-hold’ policy;

–Large Cap, Value investing, Bond fund etc.,

• High turnover indicative of active trading strategy:

–Aggressive growth, Capital appreciation, momentum trading

•High turnover creates higher transaction cost. Return must

reflect this added cost.

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Turnover and Taxes

•High turnover is not always bad. Turnover should be

judged against the objective of the fund.

• Investors may equate high turnover with market

savvy and intelligence of the fund manager.

• When market performs well, investors ignore

turnover and other cost associated with it. When

market is flat or performing poorly, this cost stands

out.

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Turnover and Taxes

•High turnover will result in higher realized capital

gains (losses);

•Capital gains must be distributed the year it is

realized; investors may be presented with a high tax

liability;

• Distributed capital gains qualifies for short term or

long term gains depending on the length of holding;

• A fund manager,with an eye toward tax efficiency,

may minimize capital gains by lowering turnover.