On January 1, 2006, a major financial daily reported the trailing 1-year and 5-year returns for Fidelity Contrafund (Nasdaq: FCNTX), a no-load mutual fund, at 16.23% and 6.21%, respectively. While these figures are informative, they only scratch the surface of what investors should consider when evaluating mutual fund performance.
To truly assess whether the fund’s performance is strong or weak, you must ask several critical questions:
- Is the fund’s performance above or below expectations?
- How tax-efficient is the fund in generating these returns?
- Are the returns in line with the level of risk the manager has taken to achieve them?
Savvy investors understand that evaluating mutual fund returns goes beyond simple numbers. Before diving into the specifics, it’s important to understand what the reported data actually means.
Total Return
Fidelity Contrafund’s reported 16.23% 1-year return reflects the total return for the period from December 31, 2004, to December 31, 2005. In practical terms, this means that a $10,000 investment made on December 31, 2004, would have grown to $11,623 by December 31, 2005. Importantly, total return includes more than just the price change of the fund’s shares. It also factors in the reinvestment of dividends and capital gain distributions (both short-term and long-term), which are assumed to be reinvested at the price at which each distribution occurs.
Compound Annual Return
The 6.21% 5-year return represents the fund’s compound annual return (also known as the average annual return). This is a calculated figure that indicates the rate at which an investment has grown, assuming consistent growth each year over the 5-year period.
For example, a $10,000 investment in Fidelity Contrafund on December 31, 2000, would have grown to $13,515.34 by December 31, 2005, assuming an annualized growth rate of 6.21%. This calculation follows the formula:
Ending Value = $10,000 * (1 + 0.0621)^5, which results in $13,515.34.
While total return and compound annual return provide useful insights, they don’t tell you how the fund has performed relative to its peers, how much investors have earned after taxes, or how well the manager has balanced risk to achieve those returns.
Relative Return
Relative return compares the fund’s performance to that of its peers or an appropriate benchmark. It shows the difference between the fund’s total return and the total return of an appropriate benchmark over the same period.
Fidelity Contrafund is a large-cap growth fund, so it’s most relevant to compare it with the performance of an average large-cap growth fund or an index like the Standard & Poor’s (S&P) 500. For the 5-year period ending December 31, 2005, Morningstar reported that the average large-cap growth fund had an annualized loss of 8.48%. By comparison, the S&P 500 had an average annual return of just 0.54%.
Fidelity Contrafund’s 6.21% compound annual return thus outperformed its peers by 14.69% (relative to the average large-cap growth fund) and beat the S&P 500 by 5.67%. This relative return shows that the fund has done well compared to both its category and the broader market.
After-Tax Return
Unlike assets held in tax-deferred accounts like 401(k) plans or IRAs, investments in taxable accounts are subject to taxes. After-tax return reflects the return earned after taxes have been taken into account.
In a taxable account, short-term capital gains and distributions are taxed at ordinary income tax rates, while long-term capital gains and qualified dividends are taxed at a lower rate.
Fidelity Contrafund’s compound annual return of 6.21% before taxes drops to 6.10% after accounting for taxes on distributions at the maximum federal income tax rates. Furthermore, the after-tax return falls to 5.33% when accounting for long-term capital gains taxes upon the sale of fund shares. This highlights the impact taxes can have on real investor returns, and shows the importance of tax-efficiency in portfolio management.
Risk-Adjusted Return
Fund managers take different levels of risk to achieve returns. It’s crucial to assess a fund’s return in relation to the amount of risk the manager has taken.
One common way to measure risk-adjusted return is by using the Sharpe Ratio, which is calculated as:
(Fund Return – Risk-Free Return) / Standard Deviation of Fund Return
The higher the Sharpe ratio, the better the fund’s return for each unit of risk taken. For the 3-year period ending November 30, 2005, Morningstar reported that Fidelity Contrafund had a Sharpe ratio of 1.74. This means the fund provided strong returns relative to the risk it took. Comparing this Sharpe ratio to similar funds can provide further insight into how well the fund manager has balanced risk and return.
Beyond Mutual Funds
While these return metrics are most commonly applied to mutual funds, they can also be useful when evaluating other investment vehicles, such as separately managed accounts, hedge funds, or model portfolios from investment newsletters.
For instance, the AlphaProfit Sector Investors’ Newsletter tracks the total return, compounded annual return, relative return, and risk-adjusted return of its Core and Focus model portfolios. These metrics help subscribers get a comprehensive view of their portfolio’s performance, with a particular focus on after-tax returns.
Summary
While total return and compound annual return are essential metrics, they don’t provide the full picture of a mutual fund’s performance. Other important measures—such as relative return, after-tax return, and risk-adjusted return—offer a more complete assessment. By using these metrics, investors can better understand how a fund is performing compared to its peers, how tax-efficient the returns are, and whether the returns are commensurate with the risks taken by the manager.
Note: This report is for informational purposes only and should not be considered as investment advice or a recommendation to buy or sell securities. The information provided is obtained from sources believed to be reliable but is not guaranteed for accuracy or completeness. Past performance is not indicative of future results. AlphaProfit Investments, LLC disclaims any responsibility for any errors or omissions in this report.