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5 Often-Misused Fund Figures

Fri, 13 Jun 2014

These fund data points are most useful in the right context.


Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to The Friday Five. Sitting in for Jeremy Glaser this week is assistant site editor Adam Zoll. He has brought five often-misused fund statistics.

Adam, thanks for joining me.

Adam Zoll: Happy to be here.

Stipp: Before we get started with these often-misused fund data points, it's important to point out that it's not that they're bad. It's just that they can be used in the wrong way, out of context, or by themselves when they shouldn't be.

Zoll: Exactly, these are not statistics that one should ignore by any means. It's just that you need to use them in the proper context.

Stipp: The first one is obviously a very important one, but it doesn't give you the whole picture, and that's total return. What's the wrong way that total returns can be used, and how should you think about total returns?

Zoll: Total return may be the most important of all fund metrics for many investors. However, it's important to remember that the total return metric represents how the fund has performed over a certain length of time, but not necessarily whether investors in the fund have enjoyed the benefits of those returns.

There is another metric called Investor Return that measures what the average investor experienced in that fund. So, for example, a fund that has lots of highs and lows, investors may have sold out during some of those lows and missed the rebound, and therefore did not enjoy as much of the overall total return as maybe they would have in a more stable fund that doesn't have those dramatic highs and lows.

Stipp: So you're not getting a sense of all the volatility that might have been behind that total return, which can cause investors to get in and get out at the wrong times, if they were using such a volatile fund.

Zoll: Right.

Stipp: The second one, Adam, is annualized return. This is looking at a fund's trailing five-year returns or trailing 10-year returns. It could be a useful data point, but it also may hide some things as well.

Zoll: It's important to remember that this is actually an average return for a fund over a given time period. So, a 10-year annualized return is how the fund performed overall on average over that time period, but it doesn't tell you how the fund got there. For example, two funds may have the same 10-year annualized return, but one of those funds may have had lots of years in which it had dramatically high returns or low returns, and the other one may have been more stable. 2008-2009, the financial crisis, is a dramatic example where one fund may have lost 50% that year and then rebounded 30% the following year, and then another fund may have lost only 30% and rebounded 20%. Overall, if you look at the 10-year returns of these two funds, they may be identical. But by looking at the year-to-year performance, you get a better sense of the road that those funds took to get there.

Stipp: Looking at trailing and looking at specific yearly returns, especially years when you know that the market had some problems or years when it rallied, can help you understand the actual performance pattern year-to-year with that fund.

The next one, Adam, is a very famous one here at Morningstar, of course, and that's the fund star rating. We do think this is a great rating, but you wouldn't want to use it just by itself.

Zoll: Exactly. The fund star rating represents how the fund has performed in the past. It's not predictive necessarily of how the fund is going to perform moving forward.

It's also important to remember that the fund star rating represents how the fund has performed within its category relative to funds of the same type. So if you have a fund that's performed particularly well within a category that has done poorly, that fund may carry a 4- or 5-star rating.

On the other hand, if you have a fund that's performed poorly in a category that has done particularly well, that fund may only carry 1 or 2 stars. But on an absolute total return basis, if you compare the 2-star fund to the 5-star fund, the 2-star fund actually could have had a higher total return. The difference in categories, against which they are measured, is the distinction that matters.

Stipp: So it's important to remember that it's a backward-looking rating, so if there was something like a management change in an actively managed fund, it could affect the future. Also the star rating is comparing funds to other funds in their categories, so you have to consider it within the category set to really use it well.

The next one, Adam, is active share, which you've written about a lot. Active share explains how a fund is different than its benchmark. It's an interesting one, but you have to know how to use it.

Zoll: Active share is a relatively new metric that has come on the scene, and it's basically used to measure how different an actively managed portfolio is from a benchmark. Investors who are paying a higher expense ratio for active management will want to make sure they are getting what they're paying for. However, the problem with the active share metric is, first of all, it's giving you a snapshot on a specific day of what the fund portfolio looks like.

It also is not necessarily predictive that just because the fund has a high active share, meaning it's very different from its benchmark, that it's necessarily going to outperform the benchmark. In fact, in some of the articles we've written for Five-Star Investor, we found that funds with lower active share in some cases outperform those with higher active share.

So yes, it can tell you how that portfolio looks, but it's not necessarily going to tell you that the fund is going perform well. Some other metrics, for example, in addition to active share, can give you more of a clear picture, like R-squared. And even taking a glance at the portfolio of your fund and comparing it to the benchmark's portfolio in terms of sector allocation and other allocations can be useful, too.

Stipp: So you really need that additional context to understand how active share might be playing into the performance of this fund over time.

The last one, Adam, is a very well-known and very well used metric for a lot of reasons, especially for income investors, and that's yield. So, what's a good way and what's maybe the wrong way to use yield?

Zoll: Yield is an important one, obviously, because a lot of investors are looking for income from their investments for living expenses these days. On Morningstar.com, we have two different yield measures: There is TTM, which stands for "trailing 12-month" yield, and there is the SEC yield.

The trailing 12-month yield can be useful because it shows the yield that the fund has experienced in the past year. However, that can change; much of that yield may have come earlier in the year, or some of the holdings may have cut their dividends over time.

The SEC yield is the yield over the previous 30-day period, ending the month before that. By comparing the two yields together, you can get a sense if there is a trend, if the yield on the fund is increasing or decreasing, and the SEC yield in particular can give you a more recent view of what that yield is.

Stipp: Five good fund metrics that become great when you know how to use them, and you use them well. Thanks for joining me today, Adam.

Zoll: My pleasure.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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