Evaluating Mutual Fund Performance

1
Evaluating Mutual Fund Performance

• Four important factors in analyzing fund
  performance
• 1. Returns
• 2. Investment Style and Risk
• 3. Portfolio Composition
• 4. Turnover and Taxes
• Examining these factors reflects how a fund
  performed in the past. Past performance may not
  guarantee future performance.

2
Returns

• Returns can be generated through
• 1. Dividend Distributions
• 2. Capital Gains Distributions
• 3. ?NAV through unrealized Capital Gains
• The importance of each component varies with the
  type of fund.
• Growth, Capital Appreciation, Foreign funds -
  realized and unrealized Capital gains
• Bond fund, Equity Income fund - Dividend and
  income

3
Returns

• Returns can be generated through
• 1. Dividend Distributions
• 2. Capital Gains Distributions
• 3. ?NAV through unrealized Capital Gains

4
Returns - Dividends

• Dividends - also called investment income, has
  two sources
• 1. Cash dividends paid stocks (quarterly)
• 2. Interest payments made by bonds and other
  fixed income securities (Quarterly or semi-
  annually).
• Fund distributes income according to its own
  distribution schedule (monthly, quarterly,.).
• Elect to receive cash or reinvest in the fund
  at its NAV

5
Returns - Dividends

• Undistributed dividends are placed in a money
  market fund (Cash like securities) until
  regularly scheduled payout date.
• Ex-dividend Date On the day the fund
  distributes its income, NAV per share declines by
  the amount of cash payout. The date on which the
  NAV is reduced is called Ex-dividend date. Board
  sets the ex-dividend date.

6
Returns - Capital Gains

• NAV can be affected by
• 1. Realized Capital Gains
• 2. Unrealized Capital Gains.
• Realized Gains are any capital gains on
  securities that a manager has sold out of the
  funds portfolio.
• Tax law permits capital gains to be distributed
  once a year. During the year, fund keeps track of
  realized capital gains and losses.
• Net Capital Gains are distributed.
• Elect to reinvest net capital gains, usually at
  POP.

7
Returns - Capital Gains

• Unrealized Gains are funds paper profits. As
  market price of securities rises, the NAV per
  share also increases.
• Any unrealized losses are also reflected on
  funds NAV.
• Therefore, total return from a mutual fund for
  a given year is determined by the dividend
  distributions, net capital gains distributions,
  and ?NAV due to unrealized capital gains.

8
Total Return

• Total return is computed for a given period of
  time, such as YTD, 1- year, 3-years, 5-years,
  10-years, etc., as mandated by SEC.
• Total Return ENAV-BNAVDISTDIV BNAV
• ENAV NAV at the end of period
• BNAV NAV at the beginning of period
• DIST capital gains distributions during the
  period
• DIV dividend income during the period.

9
Total Return

• Based on Washington Mutual Investors Funds NAV
  (Fig. 5.3)
• Total Return 32.91-30.352.60.61
  19.01 30.35
• Annualized Total Return
• Average Annualized Total Return

10
Total Return

• Discrepancy in computing Average Annualized
  Total Return
• Fig. 5.3- 1996, 1997, 1998 returns are 20.16,
  33.29 and 19.37, respectively. Therefore,
• Average Annualized Total Return
• (20.16 33.2919.37)/3 24.28, but in Fig 5.1,
  3-year average is 22.9

11
Total Return and Cost

• On-going expenses such as management fees,
  custodial fees, directors fees, 12b-1 fees) are
  deducted each day when fund computes NAV.
  Therefore, total return factors in on going
  expenses.
• Sales load (back end or front end) and
  redemption fees are not factored in. Known as
  load-adjusted total return. It is less than total
  return. Not widely publicized.
• SEC regulations mandate the formulas to be used
  as well as how the information must be presented.

12
Total Return and Cost

• On-going expenses such as management fees,
  custodial fees, directors fees, 12b-1 fees) are
  deducted each day when fund computes NAV.
  Therefore, total return factors in on going
  expenses.
• Sales load (back end or front end) and
  redemption fees are not factored in. Known as
  load-adjusted total return. It is less than total
  return. Not widely publicized.
• SEC regulations mandate the formulas to be used
  as well as how the information must be presented.

13
Evaluating Total Return

• Analyze Total Return by
• 1. Reviewing the return over 3 or more years how
  it has performed during various bull and bear
  market cycles.
• 2. Comparing returns with those of its peers over
  the same periods
• 3. Comparing return to an appropriate benchmark.
• Review Morningstar Mutual Fund Report
• Review Value Line Mutual Fund Report

14
Investment Style and Risk

• Large diversified fund protects investors
  against a decrease in the price of a single
  security.
• Mutual funds do not protects their investors
  against market or systematic risk.
• Risks associated with a mutual fund are
  determined by
• 1. Funds investment objective
• 2. Portfolio mangers investment style.

15
Investment Style and Risk

• What is Investment Style?
• On what basis does the manger choose the
  securities
• How does the fund manager analyze the
  securities.
• Three primary types of investment style
• 1. Value
• 2. Growth
• 3. Momentum.

16
Investment Style - Value

• Value Investing
• Invest in companies whose current market value
  appears to be below the companys real worth
• stock is below the value of comparable companies
  in the same business
• Manger utilize fundamental analysis to assess
  value valuation techniques of the flowing type
  is often used
• Price/ Earnings approach
• Price/ Book Value approach
• Dividend Growth approach

17
Investment Style - Growth

• Growth Investing
• Portfolio manager selects company based on
  expectation of strong growth
• underlying belief is that if a companys
  earnings growth meets or exceeds analysts
  expectations, the stock price will appreciate.
• Earnings announcements and price volatility
• Stock price volatility is high during the period
  leading up to quarterly earnings announcements
• This volatility reflects the price movement of a
  growth fund can be a Manger utilize fundamental
  analysis to assess value

18
Investment Style - Growth

• Two earnings figures that determine the
  markets and managers reactions
• 1. Earnings figure published by analysts. Usually
  more conservative number with build in
  contingencies surrounding the company and sector
• 2. Whisper number. Amount analysts expect if all
  contingencies are realistically priced.
• If the reported earnings exceeds expectations,
  price will increase, and vice versa.
• If earnings growth is projected to slow down,
  price will fall.

19
Investment Style - Growth/Value

• GARP - Growth at a Reasonable Price. A
  conservative approach that is a combination of
  growth and value styles.
• Primary method is Price- to -Sales per share
  approach.
• Fundamental valuation techniques may not be
  applicable for such companies.

20
Investment Style -Momentum Investing

• Momentum Investing
• Portfolio manager believes that the market value
  of the stock will increase rapidly
• Ignores value measures when selecting stocks
  stocks may be overvalued or undervalued
• As long as there are strong buy
  recommendations, sales and earnings continue to
  grow, exceeding expectations, stock price will
  continue to rise
• Style resembles herd mentality.
• This style is not in favor now.

21
Investment Style -Other Considerations

• Other Considerations
• Socially Responsible Investing
• Green Funds - focuses on Environmental Issues
• Fund may not invest in companies that exploits
  workers in foreign countries - case of South
  Africa.
• Investing based on Insider trading
• Follow the smart Money
• Portfolio manager tracks the trading patter of
  senior executives and other insiders in the
  company
• Their activities are reported to the SEC- public
  knowledge.

22
Other Risk Considerations

• For Foreign and Global Funds
• Currency Risk
• Country Risk
• For Bond Funds
• Bond Quality
• Interest Rate Risk

23
Turnover and Taxes

• Turnover measures how often the total holding is
  changed.
• 100 turnover - holding is changed once a year
• 300 turnover - holding is changed three times a
  year
• Low turnover is characteristic of a Buy-hold
  policy
• Large Cap, Value investing, Bond fund etc.,
• High turnover indicative of active trading
  strategy
• Aggressive growth, Capital appreciation, momentum
  trading
• High turnover creates higher transaction cost.
  Return must reflect this added cost.

24
Turnover and Taxes

• High turnover is not always bad. Turnover should
  be judged against the objective of the fund.
• Investors may equate high turnover with market
  savvy and intelligence of the fund manager.
• When market performs well, investors ignore
  turnover and other cost associated with it. When
  market is flat or performing poorly, this cost
  stands out.

25
Turnover and Taxes

• High turnover will result in higher realized
  capital gains (losses)
• Capital gains must be distributed the year it is
  realized investors may be presented with a high
  tax liability
• Distributed capital gains qualifies for short
  term or long term gains depending on the length
  of holding
• A fund manager,with an eye toward tax
  efficiency, may minimize capital gains by
  lowering turnover.