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There's More to Fund Investing Than Mutual Funds

Total return and risk-adjusted performance both support the view that mutual funds, closed-end funds, and exchange-traded funds are not created equal.

Mike Taggart, CFA, 01/29/2013

As investors, it's natural to focus on the performance of our investments. Being overly fixated on performance can lead to too much trading in our portfolios, but we like see how our decisions are measuring up nonetheless. Most investors take stock of how their investment decisions have been playing out at year-end and at tax time and then decide whether or not to make modifications.

There are, believe it or not, many ways to measure a fund's performance. You can just look at the straight-up total return over various time periods. That is, after all, what your investment has returned, assuming you've been invested and have reinvested distributions during those time periods. However, this straightforward method of looking at performance ignores volatility: How much heartburn did you have to suffer as your fund's returns lagged and then (hopefully) soared to deliver you the final total return?

Volatility-adjusted measurements of return abound. You really can have your pick. We have the Morningstar Risk-Adjusted Returns (MRaRs), which essentially adjust total returns for volatility and double ding funds for downside volatility (losing money). Research has shown that typical investors are more likely to bail out of funds on downward swings, thus increasing the chances that they may miss out on volatile funds' rebounds--hence the feature in the MRaR.

One interesting thing about MRaRs: They're not just available for open-end mutual funds, but also for closed-end funds and exchange-traded funds. As the head of CEF research at Morningstar, I've found it beneficial--to say the least--to compare category-average MRaRs across investment vehicles (mutual funds, ETFs, and CEFs). I think you'll find it beneficial, too. So let's look at one-, three-, and five-year average net-asset-value total returns as of Dec. 31 for Morningstar categories where mutual funds, CEFs, and ETFs are represented.

Performance Comparisons
For the one-year period, that is to say 2012, there were 48 categories where all three investment vehicles had category averages. CEFs had the highest NAV total returns in nearly 63% (30 of 48) of the categories and the highest MRaRs in about 60% (29 of 48). This largely was due to CEFs' use of leverage, which magnifies volatility and returns. In 2012, leveraged CEFs' returns more than made up for their increased volatility, resulting in higher MRaRs--we'll see this throughout our review.

Meanwhile, ETFs and mutual fund categories battled it out for second place, with mutual funds winning slightly more category averages.

Take the long-term bond category. If you owned the average mutual fund in that category for all of 2012 and reinvested your distributions, you're probably feeling pretty good about your 12.97% total return. Not bad for a bond fund, and you even beat the average ETF long-term bond fund with its 10.91% total return. You may be thinking, "Ha! And the news media hypes those ETFs." But look at the average long-term bond CEF: 21.64%. Move over to the MRaR and you'll see that, even taking the higher volatility into account, the return was still more than eight points higher in one year. That's the power of leverage and of closed-end funds.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.
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