Investors periodically ask about their mutual fund performance, including how they're doing versus benchmarks as well as versus stocks and other holdings. But you also have portfolio management considerations, such as the portfolio diversification.
All investors want to know whether their mutual fund returns are outperforming benchmarks. In the case of individual stocks, you have BetterInvesting methods to help evaluate individual companies and forecast whether its future performance might meet our criteria. You’re evaluating one company. But mutual fund performance is like a millipede: The topic seems to have a hundred legs.
Are Your Fund Returns Adding to Overall Portfolio Performance?
You select an individual stock for that company’s potential, with an eye to its chances to do well over the long term. An individual stock can both do well if it's in an out-of-favor industry and perform poorly if the industry is thriving.
This is less true with mutual funds, which smooth out both return and risk. So a telecommunications fund or health care fund will tend to reflect overall market sentiment for that sector. Mutual funds are valuable for their diversification factor, especially in helping you invest in sectors and industries you might be beyond your comfort level. Many investors, for example, shy away from emerging markets, small companies, and international stocks.
Mutual funds are less work for the investor than individual stocks. You need to evaluate a mutual fund, but that’s an easier project than analyzing and monitoring 50 potential stocks to narrow it down to 10 or 20 in an individual portfolio. Combining selected stocks with mutual funds that help in diversification can make for a lively animal.
Even if you only want to own mutual funds today, you should learn about the characteristics of high-quality stocks. After all, most mutual funds are baskets of stocks. You can get started by taking advantage of BetterInvesting's free 90-day digital membership offer
Do You Practice Good Portfolio Management With Your Funds?
Even if you own mutual funds, you still have plenty of work to do. You’re still the wrangler!
If you’re investing in passively managed index funds, you make decisions about what areas of the market you want to be in and make sure the fund is performing in line with those market segments. Index funds are primarily program-driven: So long as the manager sticks to the program, manager background or tenure isn't critical.
For an actively managed fund, the manager is
the fund. A manager's choices and strategy (whether successful or not) is how the fund is put together. If you have selected a fund for its potential long-term performance, you'd like evidence there’s a solid track record with the same manager, so it’s important to determine tenure. Is this the same manager who has produced success? Is the fund dependent on one or two stars, or is there a deep team with longevity? A well-built team may not be affected when someone leaves, but a star system relies heavily on a single manager or two.
A manager who has been on the job for only a few years may or may not continue the fund’s long-term performance trend. On the other hand, research tells us that over the long term, not many managers outperform indexes. Once the fund’s performance has made headlines, you’ll need to be careful that you’re not buying into the top of its market, with its best days over.
Also, do you like what your fund's manager has put in the fund? If you’re looking at a balanced fund, for example, do you like its top 20 company investments? Take the time to run a stock study on some portfolio investments — are these companies you’d like to own? Because you will!
This is particularly important for sector funds, funds with limited investments, and socially responsible or sustainable funds. Sector funds in the same industry can have very different investments, and socially responsible funds may select on very different screens than what you consider to be “socially responsible”. Anybody can call a dog a good name, but you want to know whether you’re buying a breed or mix that meets your intent.
Do Your Funds Outperform Indexes and Outperform Benchmarks?
An index fund should perform as well as its peers, or a little less than the index its tracking to account for management costs. It’s a red flag, though, if the fund return is significantly better — that's called tracking error. The index fund should mirror the index, so you should find out why it's outperforming.
On the other hand, for the increased costs associated with an actively managed fund, you should expect it to outperform its index, or else why are you paying the additional costs?
Determine what index the fund is using as a benchmark. Fund managers can select an index to match or beat that they’re pretty sure they will exceed. This is more difficult with well-understood indexes, but even they can have different qualities. For example, the Vanguard Total International Stock (VTIAX) compares itself to the FTSE Global All-Cap (ex-U.S.) index. The Fidelity International Index (FSPSX) benchmarks with the MSCI EAFE index. MSCI covers 21 countries in the developed world (Europe, Australasia, and the Far East), whereas the FTSE includes 48 countries. Although these are both international funds, they’re measuring themselves against different standards, so even if these funds hew to their indexes, they aren't the same indexes.
Check out performance over different periods as well. Look at annualized return over the long term — 15 years to see the effects of a bad market — as well as shorter periods to get a feel for performance under current conditions and maybe even the return for a particularly bad month (such as December 2018).
Investors will often find that their return doesn’t match a fund's published return. That's because the fund manager invested on a different day at a different purchase price. This performance tends to smooth out over time (unless you were very lucky or unlucky), but in the short term you can see big differences. You may want to play with tools on Morningstar or other sites that allow you to input specific dates and see how the fund would have done during your selected periods.
Use these metrics to select funds that have the legs to take you where you want to go.
Danielle Schultz, CFP, is a fee-only financial planner and principal of Haven Financial Solutions in Evanston, Illinois.