We live in a world that’s focused on measuring things. The calories in our food. The gas mileage of our cars. The good vs. bad cholesterol in our blood. And, when it comes to our financial health, the returns on our investments. But is past performance the right metric when it comes to measuring investment success?
That depends on your perspective.
- 1. Understand the objectives. Along with every mutual fund comes a fund manager, the person(s) responsible for implementing a fund’s investing strategy and managing its portfolio trading activities. Start by looking at your fund manager’s investment philosophy. You can find this information and more in the fund’s marketing literature, prospectus and website materials. You want to know the specific methodology your fund manager uses to buy and sell securities—the recipe for managing your portfolio. That process shouldn’t depend upon what’s going on with the markets or the economy today, next month or even next year. Instead, it should be a repeatable, long-term process that’s implemented consistently over time.
- 2. Think in cycles. When evaluating a mutual fund or any other investment, the time period you’re measuring can make a huge difference. For example, over the last five years, stocks have gone mostly up. If you considered a manager’s track record for only this period, you’d be looking at just one side of the equation: how the manager fared during a bull market. If you look at the manager’s returns over a longer time period that included the 2008 downturn, a different picture might emerge. As Michael Lewis observed in his book Moneyball, luck among baseball teams evens out and skill shines through. In the short term, however, skill can be overwhelmed by chance. For this reason, you’ll want to consider a manager’s performance over a complete market cycle. Doing so can shed some light on how that person views and manages risk.
- 3. Peek under the hood. How a fund manager invests is crucial to determining whether a fund is right for your needs. There are managers with attractive track records who invest in asset classes that may not be appropriate given your objectives, time frame and risk tolerance. For example, some funds may use derivatives, lower-quality securities or leveraging in an effort to boost returns. To truly understand where your returns are coming from, it’s important to look carefully at what’s inside the portfolio. Generally, you can view a fund’s holdings online at the provider’s website and/or in the fund’s semiannual and annual reports. In short, you want a manager who “sticks to his or her knitting” and doesn’t chase what’s trendy at the moment in an effort to provide outperformance. If your fund manager is supposed to buy growth companies with accelerating earnings, but you see the manager is adding distressed companies to the mix, it may be time to reassess whether the investment meets your objectives. Similarly, if value funds are having a run, but yours isn’t keeping up, you’ll want to take a closer look at whether there’s a good reason for that.
- 4. Look at the quality of returns. Context is also crucial when it comes to understanding performance. Two managers could deliver the same returns, but how they got there may be vastly different. For this reason, it’s important to understand the various risks associated with a portfolio and how they may impact your returns. Your mutual fund prospectus and periodic fund reports each provide a good place to begin understanding the external and internal risks your fund manager may face.
- 5. Keep your perspective. Investors often quote their returns in absolute terms. For example, “My portfolio was up 8 percent for the year.” But if you’re really trying to measure the performance of an investment, you also need to understand how your portfolio performed relative to the rest of the market. For example, in a bull market, a 2 percent return may be unacceptable. But in a bear market, when prices are falling, your goal may be to preserve as much of your capital as possible. In that instance, when the overall market is in negative territory, a 2 percent return on your portfolio for the year may be a win. Your wealth management advisor can help you determine an appropriate benchmark and offer perspective that isn’t always apparent from results alone.
It’s a common question many investors ask: How closely should you focus on performance? While performance is important, it’s not the most critical thing to watch. That’s because measuring investment success solely on the basis of fund returns is a lot like using a rearview mirror to drive your car. It tells you where you’ve been, but it doesn't tell you a thing about where you may be heading.
For this reason, a better approach to pursuing your long-term investment goals may be to have a disciplined process for evaluating your investments. Over time, that process may help you create and maintain a portfolio that accurately reflects your unique needs and risk tolerance—one that may help move you toward your long-term goals, regardless of what’s happening in the markets.
To learn more about how to measure the performance of your mutual funds, contact your wealth management advisor. He or she can help you assess whether your holdings, as a part of your investment portfolio, are working as hard as you are to achieve your financial goals.