Navigating the Mutual Fund Maze, Part 4: Evaluating Investment Performance

by | March 22, 2023 | 401(k) Mismanagement

Another important data point for mutual funds is their investment performance, both absolute and relative to an index or benchmark.  Investors can find this information included in the prospectus in the return bar chart and table, which shows the mutual fund’s average annual total returns, net of fees and expenses for one, five, and 10 years, or the life of the fund (whichever is less).  A mutual fund’s absolute returns are shown both before taxes and after taxes.

The more valuable information appears as the last line item in the table, which are the investments returns of an index. An index, also known as a benchmark, measures the performance of a broad asset class, such as all 500 stocks listed in the S&P 500 Index, or a narrower slice of the market, such as the 120 largest, publicly traded oil and gas companies listed in the S&P Global Oil Index.

Judging Investment Adviser Performance

Because the index will share a similar investment style (e.g. large cap, growth, value) with the mutual fund that tracks it, investors want to know how their investment is doing relative to the overall market in which they’re invested.

To use golf as an analogy, think of the index’s investment performance as the par assigned to a hole on the golf course – the active manager who beats their index has shot below par. Investors should use this information in the table to look for the investment adviser who consistently shoots near or below par. Investment advisers who actively manage their mutual funds use an index to construct a portfolio.  An investment adviser managing a large company portfolio will look to the S&P 500 Index or the Russell 1000 Index as a starting point in seeking to match the style and composition of the index. Because a passively managed fund invests in all the stocks in their index, their investment returns, net of fees, will always be slightly below that of their index.

An actively managed fund has much more latitude in what it owns. Because the active investment adviser is paid a higher fee to outperform the mutual fund’s corresponding index, investors should use the index’s investment returns to gauge how much value they are getting from their investment adviser.  An active investment adviser who consistently underperforms their index over one, five, and 10 years raises questions about how and why this continues to happen.

It also calls into question why the mutual fund’s board of directors, the so-called investors’ watchdog, has not taken steps to remedy the situation and replace the underperforming investment adviser.

Next: In part 5, the last in our mutual fund series, we will discuss the duties of a mutual fund’s board of directors to protect the best interests of shareholders.

Charles Field is Managing Partner of the San Diego office of Sanford Heisler Sharp and Chair of the firm’s Financial Services Litigation Practice Group.

Read the rest of the series: