Is Average Good Enough?

There is absolutely no doubt in an index investor's head that those who chase actively managed funds are fools. Not the Motley type, because those guys think much the same about those types of fund investors as well. But the sort of fools you suffer because you know they should know better, you know they are smart enough to do the math and lastly, you think chasing average with a index fund entitles you to a degree of smug for know how inefficient the market is.

And that's fine. An index investors is supremely confident that all will be well with their investment choice. The fact that they were able to purchase it for far less than what the actively invested mutual fund charges and that argument is always pointed out in every conversation about index funds makes the debate somewhat one-sided. Yes it is true that buying something for less is advantageous when it comes to investing. Low turnover (index funds readjust their holdings when the index they track changes) mean lower taxes (an interesting event because index funds sell losers and buy winners when they do readjust) and the combination of all of this seems to satisfy even the most average investor.

But I'm not so sure that actively managed mutual fund investors consider themselves average. Nor do they pursue such a state. In large part, because they already have it. As I mentioned earlier index fund investors like the concept of average. They embrace the inefficiencies in the market and defer the thinking about where the market will move next to the idea that spreading the risk is far more essential to protecting the underlying investment. But that protection comes with a cost.

If index funds are so much better for the investor than those of the active sort, why aren't these the only investments in use. When you look at the differences in investment styles, you find that index fund investors tend to only own index funds whereas actively managed mutual fund investors own both.

Perhaps it is the very nature of index funds. Where in almost every instance, the traditional index fund is employed, the reality of how these funds allocate the money, with the 10 companies in the index usually garnering the top 20% of the indexed dollars might lead those active investors to think that there is a chance that the remaining 490 companies in a typical S&P500 index might offer something of an opportunity.

Investing outside of index funds had been referred to investor ignorance. Betting against what are seemingly long odds of success has a certain attractiveness to the process. Call it the "what if" approach. Back in August of 2010, Lubos Pastor of the Chicago Booth School of Business and Roger Stambaugh of the Wharton School of Business wondered why do actively managed investors continue to chase these funds when the statistics offer evidence that the returns in these investments will be subpar.

To invest is to embrace the knowledge that in every investment there are two players: the one with the reason to sell and the one with the reason to buy. Trusting that a fund manager can determine which is the better side of that purchase is why actively managed funds remain more popular than index funds. True, few are skilled enough to find that pivot point but the professors have found that movement in and out of these funds, based on decreasing performance might have something to do with why they stay in these funds at all.

These investors, at least according to the professors take dispassionate rather than long look at where a fund is headed and readjust their investments accordingly. Nathan Hale of MoneyWatch believes that it instead "represents a fundamental misunderstanding of how investing works". He argues that even though actively managed investors think the additional research they do, the faith in those that they have hired because of their expertise and the fact that they have to work harder to get the returns needed to keep investors investing, Mr. Hale writes that this will  "inevitably detract from the returns you earn in the markets".

As long as the comparison of performance is skewed - benchmarks are always used when comparing the two types of investments when few if any actively managed funds hold 500 stocks in their portfolio - the proof of who is right depends on how fully you embrace the concept.

Active investors don't suggest that indexing is wrong and may have been the result of an increase in net inflows to index funds over the last several years as they moved to protect some of their portfolios. They just believe that the opportunity to do better is worth the cost, adjusting their holdings to react to lack of or increased opportunity. Mr. Hale sees this shift as the embracing of index wisdom.

Is it a "recognition of the benefits of an indexed approach" as he suggests? Or is it perhaps the simple fact that using actively managed investments are more involved, intellectually stimulating and make the investor feel like an investor? Is it an understanding that to live as a investor (using every means possible) better than simply chasing average?

Use of index funds will increase as new investors come into the marketplace, uneducated or perhaps under-educated. Auto-enrollment may add to the involvement. The use of these funds by Baby Boomers looking for some equity allocation in the final years of their work-life, realizing that some exposure is better than none may also contribute to the increased use of this passive investment. Time will tell. But actively managed mutual funds, even though maligned by index investors, will always be available to the investor.

Mutual Fund Investing: So what are mutual funds and how can they improve your life in 2011?

You have mutual funds if you have a 401(k). Individual Retirement Accounts (IRAs)hold mutual funds as the primary investment and despite their use throughout the world of investment and retirement planning, too few people have a positive attitude about what this tool can do for them. Most of the negative propaganda comes in spite of the ease of use, often lower expenses than any other investment tool, accessibility, better transparency (or well on the way to providing better insight) and often, tax efficiency. Some do this with great effort; others revamp their portfolio only when an index is restructured.

So what are mutual funds and how can they improve your life in 2011? There are only two types: actively managed or those indexed to a specific grouping of investments. From there, it gets complicated but getting from there is where the whole traffic jam of ideas begins. It makes no matter, which school of thought you ascribe to if you do at all: everyone needs and actively managed group of mutual funds and a passive group if you expect to do anything worthwhile in 2011.

In the coming year, one which is predicted to be quite good despite my doubts, which I will put forth in couple of days with my year-end look at 2011, diversity will deliver more than simply chasing one ideology of the other. The "indexers believe that these sorts of funds are all you need to succeed in any year. Offset by relatively low costs, these funds make up for hoping that that through diversity they can achieve better than average returns for those who invest in them.


As a group, index investors are a fervent bunch. They espouse this investment as the be-all-to-end-all tool and in doing so, give those who chose the other camp - the actively invested mutual fund - to wonder if they may be right. There are reams of research that indexers point to as the reason why they believe this approach. But passively sitting back and letting the market determine your investment outcome is not for everyone.


Actively managed mutual funds are structured in the same way as index funds: a portfolio of investments (stocks, bonds or both), a manager (be it one, more than one or a computer), disclosure and regulatory rules that they must abide by, and performing as billed, if not better. The difference in who picks what is in the fund. Index funds are determined by an index published by such notables as Standard and Poors or Russell or Wilshire. Actively managed funds contain investments picked by management.

Both bring like-minded investors together to pool their money and in doing so, offset the risk and cost of having to build a similar portfolio on your own. Actively managed funds try and outperform their index counterparts in large part because it is these indexes, right or wrong, in which their performance is gauged and graded. If they do better than an index, investors notice, add their money and create increased opportunities for the fund manager to increase those returns with additional acquisitions.

It doesn't always work and some comparisons are unjust (how can you compare a fund with fewer than 100 holdings to one where 500 are held?) and do not paint a true picture of performance. But in tandem, they might work for different reasons for everyone interested in a more profitable 2011.


In times of turmoil, everyone feels pain. When the whole of the marketplace dropped precipitously in 2008, no investor escaped. Some were damaged more than others but as a group, we all felt pain in some form almost at the same time. Investors who simply plowed money into a 401(k) or loaded up on their own company's stock and thought that investing was a world of do-no-wrong, were given a rude awakening. Those that traded actively on their own and were beginning to feel some invincibility creep into their results were caught unaware as well.

And in the past year, investors in US stock funds did what they had done in the previous three, withdrew more than they invested, Called outflows, they impact mutual funds harder than the selling of shares from your own portfolio. These outflowing funds are produced with the sales of a portion of the portfolio. And every such move impacts the remaining shareholders in the mutual fund.

Inflows, or your money pouring into a mutual fund comes automatically in a 401(k), through deductions into an IRA and self-deposited by individual investors. Yet only a handful of people I speak with everyday likes the idea of a mutual fund as an investment and if last year was any indication, think fund focused on the US stock market alone is not the path to financial success.


Why? We want simple things to work extraordinarily well. Nothing does but we expect it of mutual funds. We want low fees, we want moderate risk and we want to know that our money is safe from market interruptions and taxes. And at the same time, we want growth, to retire early and to have our investments perform without hiccup for decades. Only mutual funds can do this - even if we dislike the idea.

Low fees, moderate risk, safety and tax efficiency is a tall order with three of the four fitting the index fund bill. Safety is subjective and safer, even more so. But no equity index fund alone can do this. No bond index fund alone can do it either. Target date funds, hybrids of other equity and bond funds (and often a basket of such funds from the fund family) promise all of the above but have yet to prove they can deliver.


Yet three out of four isn't bad. Put this type of fund in a Roth IRA and put as much as you can in it, consistently over 2011 and you will do as well as this year has done (which looks to be two back-to-back years of double digit gains for the S&P500 index). Even if you do half as well as the 20% plus gain in 2009, you'll be way ahead of where you'd be otherwise.

In the other group, looking for growth, outsized returns and freedom from hiccups, look to your 401(k) where your employer may be retuning to offering a match in 2011. If they do, this is not so much free money as hedged money. A 6% match added to your 6% contribution gives you a lot more room to assume risk that you probably are. Retiring early is a dream even as we acquiesce to work longer. But it can be closer to a reality if two things happen: you invest more and use actively managed funds in your 401(k) to get there and the market corrects a little in the first half of the year. This means buying more for less and positioning yourself for a good 2011. Not 2010, but close.


Whatever your outlook for 2011, a tandem approach to investing - using index funds and actively managed mutual funds might be the best approach in the next year. Be cautious of only two things: this isn't advise and be careful you don't over-expose yourself in any one sector.

Mutual Funds and Performance Based Fees

Investors talk a good story when it comes to fees. While much of the conversation is begun by those who advocate index funds or exchange traded funds (ETFs are index funds that trade like stocks), the question of fees, how they should be paid and even more importantly, how much is usually based on why they (actively managed mutual funds) charge the rate they do. If mutual fund fees are so important to the investor, why haven’t they pushed harder for performance based fees?

Often referred to as the fulcrum fee, this method of charging the investor based on how well the fund manager actually did has been attempted in the past (and is currently being adopted by the Janus fund family) but has not received much more than a luke warm embrace. Is it because we simply don’t invest the way the wealthy do?

Mutual Fund Fees, Performance and the Fulcrum

by Paul Petillo, Managing Editor of Target2025.com

Mutual Funds and Performance

On Friday mornings at 8am PST, I appear on MomsMakingaMillion radio with Gina Robison-Billups and Kat Bellucci.  We discuss topics that focus on how to make their listeners independently wealthy.  The discussion has been focused on retirement investments and lately, on the mainstay of our 401(k) plans, the mutual fund.

Kat Bellucci: Last week we talked about taxes and the mutual funds inside our 401(k) plans.  Now you want to peel another layer back on the mutual funds with a talk about performance.

Paul Petillo, Managing Editor of Target2025.com: 

I don’t know about you, but I have been watching the Olympics with great interest and one thing you have to notice about the sports being played in Canada is how they are portrayed.  Three winners emerge from amongst the competitors and we give them medals.  But those that lost were the best in some other country – just not the best on this world stage.

And if you think about it, they all have plenty of reasons why they didn’t win.  Perhaps the winners had better coaching, better training facilities, better financing, you name it, they came to compete as the best among the rest of their countrymen and women but there was always someone better.  Someone who went faster, farther, didn’t fall.  It is the same with mutual funds.

Kat: How so?

Paul: Mutual funds as we have discussed are nothing more than big teams of investors who hire a money manager to lead them to victory.  He or she is the focal point.  The one we give credit to when things do go right, the one we blame when things go wrong , the one who never seems to be on that end-of-the-quarter podium.  Often, not even close.

We want to win.  The problem is, we want what someone else has, that moment when we can say we did better than anyone.  The spirit of competition, the grass is greener on the other side sort of thinking that gets us into trouble. So the first problem we have is with comparison.

Kat: Good point.  What do up suggest we compare them to?

Paul: There are numerous ways to compare mutual funds and none of them good.  The rule of thumb seems relatively straightforward and you will hear this from just about everyone: look for long-term performance, the cost of the fund, and the tenure of the manager in charge.

Kat: And I’d be willing to bet that it is not that easy, is it?

Paul:  No Kat, it’s not.  There are basically two kinds of funds out there.  Passive funds (index funds, mutual funds that follow a published index or some other list) or actively managed funds (the fund manager buys and sells what she or he wants within the confines of the fund’s charter).  Two different types of funds employing two different techniques.

Which makes the subject of performance much more confusing when actively managed funds are compared to indexes. Passive measures are poor indicators of what an active manager holds.  This is why, so often, index investors make the claim that not only do passively managed funds offer a cost advantage but because the strategy of buy-and-hold limits volatility, they also increase returns by limiting exposure to unnecessary risk.  Your cost for less risk however can be higher than the low cost of these funds. Also consider that index funds do not hold all of the stocks in the indexes they mimic.  And actively managed funds hold even less.

Kat:  So passively managed funds like indexes cost less but on the other hand, they limit risk.  And less risk means less reward.  So how do we judge actively managed funds if comparing them to an index is not such a great idea?

Paul: For quite sometime now, the mutual fund industry has warned investors that the past is no indication of the future.  They call this disclosure.  And investors use it as one of the default guides when making the choice of which fund to buy.

Over the last decade we have had two huge bubbles and two market reactions to those events.  Had you purchased a mutual fund, any fund actively managed or indexed as a bubble reached its peak, the previous five years performance would not have included how bad it did the last time the bubble burst. If the bad year happened six years ago, a five-year performance chart would not have included it. Just by removing the bad year from the five-year returns made many funds appear much better to investors and they flocked to own them again. 

Those five years offer the investor an average return. And averages suggest some odd things.  If you line-up of one hundred people, ninety-eight of whom are six feet tall, it would not change the average even if the person on one end was ten feet tall and the one on the other end was three feet in height.

Kat: So the past really isn’t an indication of future results?

Paul: These days, to get to the top of a bull market usually takes five years.  The bottom is usually hit in six months. This is a lot different than markets just a couple of decades ago. Bottoms were reached quickly while the top of the market was often a slow slog.

Kat: So we have the performance of actively managed mutual funds as compared by using index funds possessing some flaws.  And past performance leaving us with no real picture of the future based on the past, how does one judge performance? 

Paul: Without considering fees, look at the worst day the fund ever had and wonder, what if this was the day I began withdrawing money from it?

Kat: Can we talk more about this worst day performance measure next week?

A Performance Discussion on Mutual Funds

The last lines of Matthew P. Fink's book, "The Rise of the Mutual Fund" suggest that although he is a "worrier; nonetheless, I am optimistic". This speaks volumes to the "extraordinary success of mutual funds". Mr. Fink believes that despite the speculation about the maturity of the industry, it is far from falling from its exalted position. This elevated status is due, he writes "to adherence to high standards of fiduciary behavior".

Yet the mutual fund industry continues to be attacked for any number of reasons. The largest component of your 401(k) plan, your IRAs and the driving force behind numerous college savings plans, these investments are often questioned on their transparency, why they charge what they charge and even more commonly, why, if you win one quarter, can you not win the game.

Comparing Mutual Funds
There are numerous ways to compare mutual funds and none of them good. The rule of thumb for a fund is relatively straightforward: look for long-term performance (I have suggested that you also look to how well the fund manager did in poor markets rather than how they did during the good times), the cost of the fund (fees and expenses do not often tell the whole story but offer a telling sign of how much the fund manager trades and why), and the tenure of the manager in charge (an ever shifting picture as fund managers come and go and new managers look to put their investment stamp on the portfolio).

The subject of performance is often more confusing when actively managed funds are compared to indexes. These passive measures are poor indicators of what an active manager holds. This is why, so often, index investors make the claim that not only do passively managed funds offer a cost advantage but because the strategy of buy-and-hold limits volatility, they increase returns by limiting exposure to unnecessary risk. Your cost for less risk however can be higher than the low cost of these funds. Also consider that index funds do not hold all of the stocks in the indexes they mimic. And actively managed funds hold even less.

Looking at Past Performance
Performance also comes to the forefront when we look backwards. For quite sometime now, the mutual fund industry has warned investors that the past is no indication of the future. While this has been disclaimed as a method of disclosure, it is still one of the default guides for new and even seasoned investors when making the choice for which fund to buy.

Over the last decade we have had two bubbles and two market reactions to those events. Had you purchased a mutual fund, any fund as a bubble reached its peak, the previous five years would not have reflected the previous bull market's demise. I clearly remember the sigh of relief as the year 2001 was dropped from the 5 year returns in 2007. No longer would the bad bets made during the internet bubble show up as a stain on the investor information sheets. Ironically, even as some funds dove into the depths, they took the whole market down with them. (As did happen recently in 2008.)

Just by removing the bad year from the five-year returns made many funds appear much better to investors and they flocked to own them again. Averages suggest some odd things. A line-up of one hundred persons, ninety-eight of whom are six feet tall would not change the average if the person on one end was ten feet tall and the one on the other end was three feet in height.

But stock markets rarely have a peak that moves quickly from the bottom to the top whereas the bottom is often reached in less than six months. The top of a bull market takes five years, at least as witnessed over the last decade, to attain. This is not the case for any period prior to this. Bottoms were reached quickly while the top of the market was often a slow slog.

So we have the performance of actively managed mutual funds as compared by using index funds possessing some flaws. And past performance leaving us with no real picture of the future based on the past, how does one judge performance? Without considering fees, the worst day of a fund. Based on the simple idea that, if mutual funds are the primary holding in a retirement account and at one point in time, you will be begin to drawdown that account, picking the worst day to do so gives you a valuable peek at a worst case scenario. That is probably a truer indication of performance that averaging it our over a period in time. You can read more about low-mark performance here.

Next, a discussion about fees.

Paul Petillo is the Managing Editor of Target2025.com

DiWorsifying: The Art of Looking at the Downside

Most of us now realize that our mutual fund investments, particularly those in our retirement accounts, can go down, often dramatically. Until recently, we paid little attention to how bad a fund can perform, focusing instead on how well it can do.

We make random estimates of how much money will be in the account when we choose to begin drawing it down. And as we now know, this can be less than we anticipated (just ask anyone who has postponed their retirement because of a lower than expected balances). So how do you determine the performance of a fund, or better, the risk that the fund will do what you intended it to do?

Some hedge fund managers think they have the answer. It is complicated? Yes. Is it impossible for the average investor to determine? Not if you consider the manager as the sole blame for the fund's performance.

Mutual fund managers are part of the equation you use to pick a fund. Tucked in amongst the performance of the fund, the underlying holdings and the fees, we look at the fund manager's tenure. The assumption being that the fund manager will do much better the longer s/he has been at the helm. tenure also assumes that the fund will have stabilized over the period that the manager is in control.

Fund managers as we (should) know must follow the charter of the fund, avoiding style drift (a notoriously common occurrence whereby the fund manager tries to imitate whatever index works, in the hope of mimicking the return of the benchmark it will compare itself to at the quarter's end). This is managing for the upside, often shifting holdings at or near the quarter's end to give the appearance of better-than-average performance.

Some fund watchers suggest that this is not only the wrong thing to look at when choosing where to invest you fund but can cause you to assume that good times are part of the continuing experience of investing. But markets go down. How the fund manager did during this peak to valley performance is, some are beginning to realize, might be a better indication of how well the fund has done and the manager has performed.

Richard Gates, portfolio manager for TFS Capital thinks "the best way to estimate risk is to try to quantify a portfolio's downside volatility. In other words, how much money can I lose in a given period of time?"

Volatility is an excellent measure of the fund's performance during certain periods. But few of us look at the way the fund manager managed the portfolio (during her/his current tenure and better, their performance in the past) as the indication that your fund will do as expected in the future.

Fund managers are awash in information and you rely on their ability to parse this information, apply it to where you would like the fund to go in the future, and limit the downside risk. Your fund may have lost money; but did it lose as much as comparable funds (benchmarks excluded)?

Some analysts suggest that instead of looking at the best day and make withdrawal assumptions, you should look at the worst day, the moment when your portfolio looks its weakest. If is better than most, you have hooked your fortune to the right manager. But don't limit your assumptions with the current fund under management. Look at all of the performance results from every fund they have managed.

No easy task, and we will talk more about in future posts. But is another piece of the puzzle we should consider. Past results, it seems, matter more than you might expect.

A Look Outside of the S&P 500

I have been on the offensive lately. Actively managed mutual funds, which if you have followed what was written here, are taking quite a lot of criticism from the index camp. Attempting to twist their argument in as many directions as possible, refining the debate to include survivor fund rates and using numbers that skew how actively managed funds compare to their inactively managed cohorts.

I argue that the benchmark is wrong. But to get a broader look at how different categories are doing, indexes do provide a good overview of performance. Some actually come very close to doing what actively managed funds attempt in those categories; others do not.

Here is a list of how these categories did through the end of August 31st. Keep in mind, the year-to-date performance of the S&P 500 is 18.2% to the plus side. Do you know where your risk is?

Latin America Stock/62.3%
Diversified Emerging Mkts/47.9%
Pacific/Asia ex-Japan Stk/45.7%
Technology/40.6%
Foreign Small/Mid Growth/34.7%
Bank Loan/33.6%
Foreign Small/Mid Value/33.2%
Europe Stock/32.3%
High Yield Bond/32.2%
Miscellaneous Sector/30.7%
Convertibles/28.7%
Communications/26.4%
Equity Precious Metals/26.4%
Diversified Pacific/Asia/25.7%
Global Real Estate/25.3%
Foreign Large Growth/25.0%
Equity Energy/24.6%
Mid-Cap Blend/24.3%
Mid-Cap Growth/23.9%
Emerging Markets Bond/23.8%
Natural Res/23.7%
Consumer Discretionary/23.4%
Foreign Large Value/22.6%
Financial/22.6%
World Stock/22.5%
High Yield Muni/22.2%
Foreign Large Blend/21.8%
Mid-Cap Value/21.6%
Small Growth/21.1%
Large Growth/21.1%
Target Date 2050+/20.7%
Target Date 2036-2040/19.9%
Target Date 2041-2045/19.5%
Small Value/19.4%
Small Blend/19.2%
Multisector Bond/19.2%
Target Date 2031-2035/19%
Target Date 2026-2030/18.7%
Target Date 2021-2025/18.2%
Large Blend/16.7%
World Allocation/16.5%
Target Date 2016-2020/16.1%
Moderate Allocation/15.6%
Target Date 2011-2015/15.5%
Target Date 2000-2010/15%
Muni Single State Long/14.9%
Large Value/14.5%
Consumer Staples/14.3%
Muni New York Long/14.1%
Muni New Jersey/13.9%
Conservative Allocation/13.8%
Muni National Long/13.5%
Retirement Income/13.3%
Muni California Long/13.1%
Real Estate/13%
Muni Massachusetts/13%
Muni Pennsylvania/12.9%
Industrials/12.6%
Health/12.4%
Muni Minnesota/12%
Japan Stock/11.9%
Long-Term Bond/11.9%
Intermediate-Term Bond/10.6%
World Bond/10.3%
Muni Ohio/9.8%
Muni Single State Interm/9%
Muni National Interm/8.7%
Muni New York Int/Sh/8.6%
Muni California Int/Sh/8.1%
Utilities/7.8%
Short-Term Bond/7.4%
Inflation-Protected Bond/6.9%
Long-Short/6.3%
Ultrashort Bond/6%
Muni Single State Short/4.7%
Muni National Short/4.3%
Intermediate Government/3.7%
Short Government/2.6%
Currency/-1.8%
Long Government/-11.3%
Bear Market/-27.2%

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.

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.