Mutual Funds Explained: Measuring Mutual Fund Performance Using a Rolling Average

In a previous post on performance, I wondered if there was a way for investors to measure how well a mutual fund has done. Mutual fund managers often use comparison to less risky indexes as the benchmark for their own performance. This, we all know, enhances how the fund appears to have done. Right or wrong, I suggested that the ultimate guide to performance may lie in the investor; the person in the mirror who must assess their risk, their goals, and their expectations.

Richard Gates, portfolio manager for TFS Capital agrees. Interviewed recently at Forbes, he said: "I think the root of the problem is not really how returns are measured and presented. Rather, I think the basic problem is that investors just shouldn't be so fickle about short-term performance." And that accounting of performance is what we are faced with, almost daily.

The short-term also presents other problems. For instance, how can you tell whether a mutual fund manager simply has lost her/his/their touch even as the market declined for every fund? In other words, is bad really the fund manager's fault? Or is doing bad something entirely different?

It would be nice to throw 2008 out of the equation. But for the next five years, that year will show every fund as underperforming even as we forget about what happened in 2008, probably soon after we turn the calendar on 2010. The real test is how well they have done since March of this year (2009). But that would be looking to the short-term in the hope of finding some long-term potential. Is it possible?

Is it right to do so? Possibly not. If you are an investor, 2008 looked really bad. Yet, never have investors had such a clear understanding of what worst-case scenario looks like. Bear markets toughen investor hides across the board. Sure, many run for cover. But those that understand that bad can be turned into good, relish the opportunity to grab a once in a lifetime (or perhaps once in a five year cycle would be more like it) chance at finding out what worked and what didn't and even more importantly, why.

Keep in mind, even as funds fell, so did their comparable benchmarks. Were they still able to match, even beat those benchmarks in a down year? Did the fund family pursue a cost-cutting, fee stripping strategy to help boost your return, however meager? Did they look out of house for a different manager to run a fund that was really beaten down?

If your fund manager is still at the helm as I write this, look at their performance over the past ten years to get what is called a rolling average. Compare that number with the benchmark's rolling average over the same period. Then compare it to the peer group, using the same investment style as a comparison.

Then look at your risk factor again. The investor in the mirror will need to make some choices as well. And whatever you do, do not eliminate too much risk. Let your fund manager do what he can to mitigate out-sized risk as they struggle to regain your confidence and at the same time, increase their performance.