Monday, July 6, 2009

Mutual Funds: Measuring Performance May Not Be Worth The Effort

Point A to Point B. Simple. Clean. Understandable. Investing is none of that yet it is more or less how we approach the subject. This is particularly true of mutual fund investing, where performance falls at the top of the list. Unfortunately, it may not be as measurable (even worth measuring) as we had thought.

The Mirror Effect
Mutual fund investors often fail to correlate the actual returns on their investments for two reasons. The portfolio they own is subject to constant investment and sometimes, if the fund is held outside of a retirement account, withdrawals. The return on your mutual fund statement does not reflect any of those transactions. Instead, it would mirror your portfolio had you done nothing at all.

This of course is virtually impossible to do. Oliver L. Velez and Greg Capra identify this mirror effect in their book "Tools and Tactics for the Master Day Trader" when they write: "Every consistently losing trader sees the market as this angry foe that must be overcome, tricked or even conquered. In the loser's mind", they warn begins to believe "the market is out to get them."

They point out that once this begins to dominate the traders mind, "the market, being the perfect mirror that it is, cast that very perception back, in every detail." The winning trader ironically sees the same market differently, not surprisingly as friendly, warm and welcome, willing to bend to her/his every move.

Measuring Mutual Fund Performance
We have looked at numerous ways to determine a mutual fund's performance from weighing the manager's tenure and experience against a group of his peers. Newer managers realign portfolios and attempt to regain investor confidence with their skills mostly designed to gain in the short-term. But often what they do is lumped together and left to the investor to sort out.

Mutual funds are often guided by a charter that we have all found, is only a loose interpretation in many cases of exactly where the fund is headed. Barriers between growth and value styles of investing drop and the blurry boundaries between what is a mid-cap and what is a small-cap, what is a large-cap and what is a mid-cap, often add to the confusion. Last minute window dressing at the end of a quarter also creates a distortion that the average investor often cannot measure. Most professionals have a difficult time with "noise" as well.

One other thing that cannot be successfully unraveled is the relationship between luck and skill in the fund manager's results from one year to the next, one quarter to the next. In many cases, there is simply not enough time to make good judgments even though a decision must be made. So comparisons must be made and this is where the errors begin to surface. Most funds will chose a measurement that carries less risk and therefore less in potential returns.

This is the point in the discussion where you come down on one side or the other. Many market measurements still point to the success of index fund investing over actively managed funds. In the long-term, indexes do win. But they win because they are tax-efficient and because they cost less.

Here is the problem. If you are investing in a tax-deferred account, the chances of winning in a more actively managed fund, one that is reexamined each year for performance and expectations should provide you with a better need of the working cycle return that an index fund in the same place. Actively managed funds take more work while index funds do not. But removing risk does not replace returns evenly. And in many cases, fees have also dropped considerably as well.

To measure how well your fund is doing, perhaps the only way that you can successfully do it means that you should look in the mirror first and ask yourself the same question.

No comments: