Measuring the Relative Performance of a Mutual Fund

Investing In Mutual Funds

Investing In Mutual Funds

Do you know how to measure your mutual fund performance? Are your personal finances allowing you to start using your savings as another way to earn money?

To most, assessing the true performance seems like a complicated task.  Many advertisements tout certain funds as having 5-star ratings or as being the “best choice” for American investors.  But how exactly are these performance ratings determined?  Can these ratings be trusted?  What exactly do we mean when we say a mutual fund generated a return of 20% and does this give us the true picture of a fund’s performance?

It can be very easy to get caught up in the hype of the media advertisements attached to many mutual funds, so making the best choice in a mutual fund investment requires a solid understanding of how performance should be measured.  Here, we will look at how to measure the relative performances of mutual funds so that we can properly assess the claims made in their advertisements.

Using the Morningstar Style Box

The first step in accurately assessing a fund’s past performance is to look at the Morningstar Style box, which divides mutual funds by market capitalization (small, medium and large) and by its investment objective (value, growth, and blend).  The box has 9 sections and can be seen in the graphic below:

This configuration allows you to place your chosen fund its correct category (one box on the “tic tac toe” spectrum).  This is helpful because it will allow you to compare total performance (rates of return) with funds of a similar size and investment approach.  Typically, investors make these comparisons over 3, 5, and 10 year time horizons (allowing you to smooth out short term fluctuations in the market).  Of course, performance comparisons can also be made relative to a benchmark index like the S&P 500, but the more specific performance comparisons (to those funds in a similar Morningstar category) tend to be more useful.

Separating Your Fund from the Market as a Whole

When looking to make an assessment of the market as a whole, the S&P 500 can be a useful benchmark for determining broad economic performance.  But in order to have a meaningful idea of your fund’s true merits, it must be compared to its peers those within the same style box category.

For example, roughly 90% of the available mutual funds underperformed the S&P 500 in 1998.  Index funds tied to the S&P 500 fall into the “blend” and “large cap” fund categories (which suggests that the S&P 500 has limited exposure to value and growth stocks).  In this year, as most mutual funds offered weaker returns than investments in the S&P 500, a majority of the similarly categorized “large cap” and “growth” funds actually beat the S&P 500 index.  From this, should we surmise that the managers of these funds put forward an exceptional performance?  Not exactly.

In 1998, growth funds with large market caps generated average returns of about 35% (which was about 8% better than what was seen in the S&P 500).  But some funds (such as the Vanguard Growth Index fund) generated returns above 42% for the year.  So, when some funds advertise the performance as “market leading” because they beat the S&P 500 benchmark, the first question to ask is whether or not the fund falls into the “large cap” and “growth” categories.  If this is true, you should not be as impressed by these results as you would be if the fund fell into one other categories (which would be a more impressive feat).  This is because the assets in that fund should have had no problem beating the S&P that year.

Matching Comparable Funds

There are some names that are well known in the fund community (such as Vanguard) that aim to provide access to index funds which fall into many of the Morningstar style boxes (Vanguard funds fall into 7 of these 9 categories).  So, when looking for funds to use as a measured standard of performance, these funds provide a good starting point.

Morningstar.com allows you to search for your fund using its name or ticker symbol.  You will then see a wide selection of informational articles related to the fund.  This will include its style box categories, yearly performance relative to the S&P 500 (for assessment against the broader market), and performance comparisons to funds that are more directly related to your fund of choice.   A quick internet search of this type can allow investors to assess the relative performance for mutual funds before making any share purchases.

SmartMoney’s Comparison Tools

Other sites, like SmartMoney.com, will allow you to compare funds through time periods of 1, 3, or 5 years.  These types of sites allow you to monitor how the funds in your 401(k) plan are performing when compared with a similarly positioned index fund.  The Vanguard funds make these comparisons particularly convenient and the following list shows which funds are comparable for each style box category.  You can use the ticker search at SmartMoney.com to look for these match-ups:

  • Small Cap Funds: Vanguard Small Cap Index Inv (NAESX) compares to the Russell 2000 Index
  • Mid Cap Funds: Shelton S&P Midcap Index (SPMIX) compares to the S&P Mid Cap 400 Index
  • Large Cap Funds (Value):  Vanguard Value Index (VIVAX) compares to the BARRA/S&P Value Index
  • Large Cap Funds (Growth):  Vanguard Growth Index (VIGRX) compares with the BARRA/S&P Growth Index
  • Large Cap Funds (Blend):  Vanguard 500 Index (VFINX) compares to the S&P 500 Index

In addition to this, Vanguard has addressed other style box categories with a value fund in the small cap category (VISVX), as well as a mid cap index fund (VIMSX).  But since these are recent additions to the market, there is not enough of a historical record to allow for a meaningful analysis.  Instead, when looking at mid cap funds, other options include the California Investment Trust S&P Midcap Fund (SPMIX).  When looking at small cap funds in the growth or value category, investors can compare the chosen fund with those in the blend index funds with small market capitalization.  One example is the Vanguard’s Small Cap Index Fund (NAESX).

Conclusion:  Market Returns and Performance Ratings are Only Meaningful When Compared to Their Peers

Making a comparison of the annual returns generated by your chosen fund to those generated by a similarly positioned index or index fund will allow you to accurately assess the track record and measure its performance on a relative basis.  In many cases, these performances are less than impressive, despite what the fund’s marketing team might suggest in advertisements.  In other cases, a fund will outperform its peers (and its associated index), so an investor’s main task is to identify a fund that consistently outperforms relative to its competition.

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