How to Dissect Mutual Fund Returns!

How to Dissect Mutual Fund Returns .. A leading financial daily reported the trailing 1-year and 5-year returns of Fidelity Contrafund
(Nasdaq: FCNTX), a no-load mutual fund, as 16.23% and 6.21%,
respectively. While the financial daily’s return information is useful,
there is more to mutual fund returns.

• Is the performance of the fund superior or inferior?
• How tax-efficient is the fund in delivering these returns?
• Are the returns of the fund commensurate with the risk the fund manager has taken to achieve them?

Savvy investors will seek answers to such questions when evaluating
mutual fund returns. Before delving into the specifics of mutual fund returns, it is important to understand what the data reported in financial daily means.

Total Return

Fidelity Contra’s reported 16.23% 1-year return is the fund’s total return for the December 31, 2004 to December 31, 2005 period. In practical terms, $10,000 invested in the fund on December 31, 2004 is worth
$11,623 on December 31, 2005. The total return includes more than the increase (or decrease) in the fund’s share price. It also assumes reinvestment of all dividends as well as short-and long-term capital gain distributions into the fund at the price at which each distribution is made.

Annual Compound Return

The reported 6.21% 5-year return is the fund’s compound annual return (also called the average annual return). The compound annual return is a calculated number that describes the rate at which the investment has grown over a 5-year period assuming uniform year-over-year growth.

A $10,000 investment in the Contrafund on December 31, 2000 has grown to
$13,515.34 on December 31, 2005. The ending value of $13,515.34 =
$10,000[(1 + 0.0621)5] where 6.21% is the compound annual return. The investment in the fund grew at an implied annual growth rate of 6.21%
over the 5-year period.

While total return and compound annual return are useful, they do not tell us how a particular mutual fund has performed compared to its peers.
They also do not provide information on the return actually earned by investors after accounting for taxes. Finally, they do not offer insight on how well the fund manager has managed risk while achieving returns.

Relative return

It compares the performance of a mutual fund with its peers. It is the difference between the total return of the fund and the total return of an appropriate benchmark over the same period.

Fidelity Contra is a large-cap growth fund that primarily invests in U.S.-based companies. It is therefore appropriate to compare its performance with that of an average large-cap growth fund. It is also relevant to benchmark the fund against the Standard & Poor’s (S&P) 500 index, which is comprised of large U.S.-based companies.

While Fidelity Contra has a compound annual return of 6.21% for the 5-year period ending December 31, 2005, Morningstar reports the average large-cap growth fund has an average annual loss of 8.48% over the same period. The S&P 500 index has an average annual return of 0.54% over the same period. Fidelity Contra outperformed the average large-cap growth fund and the S&P 500 index fund, with a relative return of 14.69% and 5.67%, respectively.

After-Tax Return

Unlike assets held in qualified accounts such as 401k plans or individual retirement accounts (IRA), assets held in regular individual or joint accounts are not tax-deferred. For such non-qualified accounts, the after-tax return is the return realised after accounting for taxes.

Short-term capital gains and short-term capital gain distributions from mutual funds are currently taxed at the same rate as earned income.
Dividends, long-term capital gain distributions, and long-term capital gains realised from the sale of fund shares are currently taxed at a lower rate.

According to Fidelity, the 5-year compound annual return for Fidelity Contra before taxes is 6.21% as of December 31, 2005.When all distributions are taxed at the respective maximum possible federal income tax rate, the after-tax return dips to 6.10%. The after-tax return drops further to 5.33% after accounting for the long-term capital gain tax due on the sale of the fund shares.

Risk-Adjusted Return

Some fund managers take more risk than others. It is important to assess a fund’s return in light of the amount of risk the fund manager takes to deliver that return.

Risk-Adjusted Return

is commonly measured using the Sharpe Ratio.
The ratio is calculated using the formula (mutual fund return-riskfree return)/standard deviation of mutual fund return. The higher the the Sharpe ratio, the better the fund’s return per unit risk.

Based on returns for the 3-year period ending on November 30, 2005,
Morningstar reports Fidelity Contra’s Sharpe ratio as 1.74. The fund’s Sharpe Ratio may be compared with those of similar funds to determine how the fund’s risk-adjusted return compares with those of its peers.

Beyond Mutual Funds

Return concepts such as relative return, after-tax return, and risk-adjusted return may also be used for evaluating separately managed accounts, hedge funds, and investment newsletter model portfolios.

The AlphaProfit Sector Investors’ Newsletter, for example, tracks the total return and compounded annual return of its Core and Focus model
portfolios. To provide subscribers with a more complete picture of model
portfolio returns, this newsletter also tracks the relative risk-adjusted returns of the model portfolios. The newsletter’s model
portfolios are constructed and repositioned with a view to maximising after-tax returns.

Summary

While total return and compound annual return are useful, they do not provide a complete picture of a mutual fund’s performance. Metrics such as relative return and after-tax return offer insights on the fund’s relative performance and tax efficiency. Risk-adjusted returns enable investors to assess how a fund’s returns stack up when risk is factored in.

Notes: This report is for informational purposes only. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice. This report does not have regard to the specific investment objectives, financial situation, and particular needs of any specific person who may receive this report. The information contained in this report is obtained from various sources believed to be accurate and is provided without warranties of any kind.
AlphaProfit Investments, LLC does not represent that this information,
including any third party information, is accurate or complete and it should not be relied upon as such.

AlphaProfit Investments, LLC is not responsible for any errors or omissions herein. Opinions expressed here reflect the opinion of AlphaProfit Investments, LLC and are subject to change without notice. AlphaProfit Investments, LLC disclaims any liability for any direct or incidental loss incurred by applying any of the information in this report. The third-party trademarks or service marks appearing within this report are the property of their respective owners. All other trademarks appearing herein are the
property of AlphaProfit Investments, LLC.

Owners and employees of AlphaProfit Investments, LLC for their own accounts invest in the Fidelity Mutual Funds included in the AlphaProfit Core and Focus model
portfolios. Fidelity Investments or other mutual fund companies mentioned in this report are not associated with nor receive any compensation from Fidelity. Past performance is neither an indication of nor a guarantee of future results.

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