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.

Mutual Funds vs. Stocks: Better, Cheaper, Easier?

Fellow blogger Jenny Decki at BeyondMom asks the following questions:

Why would I invest in a mutual fund?

If I choose five stocks (or 10 or 15) isn’t that (basically) the same thing as being in a mutual fund but without the fees?

I understand that a mutual fund has a manager that watches the stocks within the fund and makes changes as appropriate, but how is that different than day trading? (Other than the fact it’s someone else doing the day trading.)

Jen,

You raise some interesting questions: can you do what a mutual fund does and can you do it cheaply enough to make it worthwhile?

Mutual funds are still both cost effective, tax efficient, and in many cases, a far better investment than wading into the world of stock picking. Yes, mutual funds offer a fund manager(s), a level of research and discipline often not found in the individual investor, and the ability to diversify into a wide variety of stocks. Whereas the individual investor has far more flexibility to sell at moment's notice, some basic problems arise from the effort.

1. Which stocks to buy? While it depends on whom you listen to, the stock market has yet to retain any long-term stability. News, even reports that seem wholly irrelevant to the shares you might own, is still driving the investor to do things they would not normally do during a more stable and predictable market. True, no market offers itself to forecasts, and no stock is immune to industry trends, they can be and should offer some sort of confidence, a belief that the decision they have made is the right one long-term.

2. Which stocks offer long-term stability? Legendary investors always look for value. The average investor looks for gains. The two can be compatible but patience and time are what turns value into profits. Those looking for gains generally do not bring that sort of approach to the effort. Build a sample portfolio at any one of the financial portals and you can test this discipline before you commit real dollars. Keep in mind that these sample portfolios do not usually simulate trading charges or taxes.

3. Are stocks cheaper in the long run? Only in the long run. If you spend a fair amount of time looking at the tickers crawling across the bottom of broadcasts on CNBC for example, the wildly traded moves, the end of session strategies employed by many ETFs (exchange traded funds), and the instant reaction that many of these floor traders have to news (the ability to disseminate what is important right that minute to whatever position they may have taken) is very difficult for the average investor to control. Buying and selling all have costs (to you they are more expensive; to the institutional investor these costs are much lower) and depending on how much you have in your brokerage account, the advertised price many broker offer will be much higher.

4. Are stocks cheaper than mutual funds? Those same legendary investors offer the same legendary advice: fund your retirement, keep your financial house in order and only invest in individual stocks with money you do not need. Benjamin Graham, one of the most legendary of investors coined the term "Mad Money" to describe these accounts. He suggested that you should only put in money you do not need and never replenish those funds (if you win great; if you lose, lesson learned). Investing in stocks, for lack of a better analogy, is gambling. Ask yourself this: if you were at a casino and you had spent all of the cash in your pocket, would ask for a line of credit to continue?

That said, mutual funds still offer you the best way to keep your money working in the markets without taking outsized risks. Keep actively traded funds in your retirement account (the tax deferred opportunity is wasted on index funds in these types of accounts - keep them outside of your retirement account and pay the taxes on the gains and get the tax break on the losses). Be sure to take the time to build an adequate emergency account so you will never touch those retirement investments (these accounts are often referred to as savings - they are not), and if you still have money left over, wade into the ocean of stocks.

As Warren Buffet once said (as legendary an investor as you could quote):"price is what you pay; value is what you get."