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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Your Mutual Fund's Returns Aren't As Good As Advertised -- Here's Why

Ever feel like the return you are getting on your investments is not the same as what the market is doing -- or even what your own mutual fund says its return was?

Well, you are probably not imagining things.

In fact, you aren't the only one experiencing this variation -- it happens to virtually everyone!

Just the other day, I was reviewing my investments and found one mutual fund with a return of 12.86% for the previous year, and the mutual fund's reported return was 13.38%.

Am I upset? No! 

Should we call in the regulators? No need for that. 

The variance is easily explained and is a natural part of investing on a regular basis.

Why is this happening, and what do you need to do with this information?

Let me explain...

Why Your Investment Returns Are Different

When a mutual fund reports on its performance for the year, it starts with a lump sum amount on Day 1, factoring in distributions and any price changes to get the return for the year.

Here's the formula:

[(New Price - Purchase Price + Dividends) / Old Price] X 100

And here's how it could work:

  • The purchase price on January 1 for a mutual fund share is $10.
  • They pay out $1 in dividends during the year.
  • On December 31, the new price is $12.
  • Their total return for that year is 30% -- [($12 - $10 + 1) / $10] X 100.

But that's not really how things go in the real world. Most people don't buy an investment on the first day of the year and leave it alone throughout the year. Instead, you may add money every few weeks via a 401(k) -- or you might miss a dividend payout because you invested too late in the year. These are just a few of the reasons your return will be different from that of the mutual fund.

Here's a more realistic example:

  • You invested in the fund on January 21 at the purchase price of $11.
  • You missed the dividend ex date (the date by which you had to own the stock in order to collect your dividend payments) so you did not get dividends.
  • The price at the end of the year was still the $12 per share. 
  • Your total return is 9% -- [($12 - $11 + $0) / $11 X 100.

Here are the main reasons your returns will be different from your fund's reported performance.

  • The timing of your investment: Maybe you emotionally sold your stock at a low point or bought at the high. Perhaps you invested on a regular time frame, such as with a 401(k), instead of doing so in one lump sum at the first day of the year. However you do it, it is easy to miss the best and worst days of a fund’s performance by even just a day.
  • The timing of the distributions: When a fund makes a payout of dividends or capital gains, it does so based on the owners of the fund at a certain date. In short, if you're not in the fund at the right time, you won't get that payout. That lowers your return.
  • Load or sales charges: These are typically not taken into account when funds calculate their return. However, they do impact your return because they immediately lower the value of your investment.

How To Use Your Returns To Manage Your Portfolio

Now what should you do with this information?  When I am evaluating my portfolio, I use my actual return and not the fund's reported return to make comparisons to the appropriate index.

Follow these steps for your own portfolio:

  1. Determine your return: How you track your investments will determine how you figure out this number. I use Quicken, which provides me with built-in average annual return reports. However, in the past, I have also used Excel and its XIRR function. Look at your tracking tool and see if a reporting feature is available. If not, open up Excel and use the XIRR function with the transactions from your account.
  2. Determine what to compare it to: For example, with a small-cap fund, you may decide to use the Russell 1000.
  3. Make sure it's an apples-to-apples comparison: Now compare the index and your return, and make sure you are comparing the same return calculation. (Most funds use the average annual return, but you will want to read the fine print to confirm this). If your return is higher -- congratulations!  If it is on par or below the index, it is time to dig deeper into the numbers and the mutual fund to decide if it is still the right investment for you.

The Investing Answer: Don’t just take your fund's reported return as your own return.  Instead, take the time to run your return numbers. This helps you make educated decisions about your portfolio and its performance.

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