Putting your mutual fund return in perspective

The first question that comes to the mind of an investor while investing in any asset is the return it gives. So if you are investing in a mutual fund then you would definitely like to know how much money the fund has made? Despite knowing the fact that a fund’s past returns don't exactly predict its future returns, most of us check their past performance to know what we can expect in future. Therefore understanding return is a basic necessity for an investor.

All the return of a MF scheme that you see in the websites and business newspaper are total return that a fund has generated in a given period. They reflect two things: market gains or losses in the stocks or bonds the fund owns and income received from those investments. Income comes from the dividends paid by stocks and the interest paid by bonds the fund owns. Together, these capital returns (increase in stock or bond prices) and income returns make up the total returns of a fund.

These total return figures for a period greater than one year are normally annualised and are not cumulative. Here’s another important convention related to funds’ total-return figures: Total-return numbers for periods longer than one year are typically represented as annualized, rather than cumulative, returns. What’s the difference? A fund’s cumulative return is the total amount it has made—in percentage terms—over a given time frame. For example, if you have invested Rs. 10,000 into a fund that went on to return a cumulative 150 per cent over the next three years; you’d have Rs. 15,000 at the end of that three-year period. An annualised return, meanwhile, is something like an average return over a given time period, except that it takes compounding into account. For example, in the above case an annualised return would be 14.47 per cent.

Putting returns in perspective

Now you know your fund’s return and what its constituents are. Besides, you also know the returns it has provided in the past. It will not help you in taking any decision. For example, you own a fund that has gained an average of 15 per cent every year for the past five years. However, one of your colleague claims to have a fund that has gained 17 per cent per year during the same period. Without context, unless you know what types of fund you own, the numbers are meaningless. To know how well a fund is doing, you need to make relevant comparisons. Use an appropriate yardstick such as a stock or bond index or a group of funds investing.

Compare within category

Comparing an investment with index may not be right all the times. Therefore, comparing with categories may be the correct way. The categories allow you to compare your fund’s performance with that of other funds that invest in the same way. An index may be a suitable benchmark because it tracks the same kinds of stocks that your fund invests in, but an index itself isn’t an investment option. Your choice isn’t between investing in a fund and an index but between a fund and a fund.

Now you have compared your fund to the appropriate peer group. Its returns stack up well relative to its peers over a variety of time periods, however, you still have a little bit of work to do when evaluating its past returns. That’s because the total-return figures you typically see don’t include the bite taxes can take out of your return. When a fund distributes income or capital gains to shareholders, you, the shareholder, are required to pay taxes on those distributions (regardless of whether you were around to receive them or not!). And, of course, paying taxes cuts into your take-home return.

Hence, before selecting a fund purely based on returns you should check the above points before arriving at the right fund for you.