Episode #45: How to Analyze Mutual Fund Performance [Part III of Mutual Fund FUNdamentals]

Mutual Fund Performance












December 8th, 2020

How do you properly analyze mutual fund performance? Does the historical performance of a fund give you the full picture? The short answer is no. I’ll answer the “why” in this episode of Making Finance Fun. I’ll talk about benchmarks and tracking error. I’ll compare actively managed funds, passively managed funds, and bond funds. The goal of this episode is to give you context to be able to judge the performance of any mutual fund. Don’t miss it! 

Outline of This Episode

  • [0:42] Mutual Fund Performance
  • [3:20] Passively managed/index funds
  • [4:18] What is tracking error?
  • [7:09] Compare a mutual fund to its proper benchmark
  • [10:01] Actively managed domestic (US) stock mutual funds
  • [16:35] Bond mutual fund benchmarks

Passively managed funds and tracking error

When people ask me about performance, they’re generally asking about actively managed mutual funds. They don’t exist to surpass or beat an index—but simply to copy it. If you’re looking at their performance, it should mirror the underlying index it’s trying to track and copy (i.e. S&P 500 or the Dow Jones). There shouldn’t be much of a performance difference. 

But tracking error might creep in. What is tracking error? Let’s say—hypothetically—that this year the Dow Jones averaged a 10% annual return. Your mutual fund that’s copying the index only returned 9%. That’s a 1% tracking error. Tracking error should be very small—almost completely unnoticeable. But a passive fund won’t perform exactly the same as the index they’re tracking. Just keep this in mind as you’re analyzing passive mutual funds.

You need to compare a mutual fund to its proper benchmark

If there’s one thing that you take away from this episode, let it be this: as you’re analyzing actively managed mutual funds, do not analyze them on a standalone basis. You HAVE to compare them to the proper benchmark (for this discussion, I use “benchmark” and “index” interchangeably). You can’t compare a large-cap stock fund to a small-cap index. You can’t compare a bond mutual fund to the Dow Jones. They are two completely different things. It’s like comparing gas mileage in a Toyota Prius to a Dodge Ram. It won’t help you. 

Actively managed domestic (US) stock mutual funds

You can look at the average annual return to gain some perspective—but don’t put too much weight into it. Why? Because they ALL say “Past performance does not guarantee future results.” They’re not lying to you. You can look at historical performance, but it doesn’t mean it will be indicative of the future.

What should you look at? The “style box.” According to Investopedia, “A style box is a graphical representation of a mutual fund’s characteristics.” It’s a box with smaller boxes inside it. Each box represents a type of stock in one of three categories: Value stocks (under-valued, like Dollar Tree) and growth stocks (a company that’s growing like Tesla, Netflix, etc.). In the middle, you have a blend of both (i.e. Caterpillar). 

It’s a simple tool that tells you where the mutual fund fits into the style box to analyze against the proper benchmark. If you buy a large-cap value mutual fund, you don’t want to compare it against a large-cap growth index. You want to compare it against a large-cap value index. It gives you the proper perspective and helps you look at the “style” of your mutual fund.

The whole point? If you’re looking for a pure growth mutual fund, compare it to a pure growth index. The style box can help you do that. 

Bond mutual fund benchmarks

People are often really confused by bonds. The most popular bond index is the US Aggregate Bond Index from Barclays. There are also corporate bonds, municipal bonds, government bonds, etc. There are high-yield, triple-A rated, etc. If you’re looking at a high-yield bond fund, don’t compare it against the Barclays AGG index—compare it to a high-yield index. If you’re looking at a short-term index, don’t compare it to a long-term index. It won’t give you any relevant information.

You can’t just look at whatever mutual fund you want and say, “Oh, it averaged 8% annually for the last 30 years.” That doesn’t tell you the risk you’re taking. It doesn’t tell you what performance you can expect in the future. You need more perspective to find out how it will perform in changing market cycles. It’s just like how you need to listen to the whole episode to understand the full depth of the information I’m sharing! 

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