Is That Fund as Good as It Looks?

Question: I've seen references to both trailing and rolling returns on Morningstar.com and elsewhere. What do those terms mean? Is there a difference, and if so, what is it?

Answer: They might sound similar, but trailing and rolling returns provide distinct views of an investment's past performance. And though trailing returns are more commonly cited than rolling numbers, both can be a useful part of your analytical process.

Trailing Returns
A trailing return looks backward from a particular date for a fund's annualized return over a specific time period--usually ending on the last day of the most recent day, month, quarter, or year. If you pull up any mutual fund quote page on Morningstar.com and click on the Performance tab, you'll see a chart of the fund's trailing total returns for various time periods, from one day to 15 years, as well as how it compares with a market benchmark like the S&P 500 and other funds in its category. (You can also see the same data for individual stocks on the Performance tab.)

For example, as of the most recent quarter ended March 31, Rydex Dynamic NASDAQ-100 2X Strategy (RYVLX) posted a one-year trailing return of a whopping 36.76%, and more modest three- and five-year trailing returns of 8.12% and 2.89%, respectively. Those trailing-return figures represent how much the fund returned on an annualized basis as of March 31--one-, three-, or five years ago--until the most recent quarter ended March 31. Keep in mind that trailing-return figures assume reinvestment of both dividends and interest payments as well as capital gains or losses. The fact that longer-term returns are reported on an annualized basis means that we use a time-weighted geometric mean of the returns for a multiyear period. Annualized returns are standardized figures that take into account any contributions or withdrawals.

Trailing returns are a useful tool, particularly if you're comparing two investments with each other or are assessing how your fund has performed versus a market benchmark. But these statistics also present a simplified view of a fund's performance. A fund's trailing short-term returns may seem attractive, but they may disguise how volatile the investment has been during a longer time frame. If the fund's recent performance has been very strong, that can bias a fund's trailing returns for the better, masking past problem periods. That's where rolling returns come in handy.

Rolling Returns
Rolling returns display returns in overlapping cycles starting on the first day of the month--going back as far as the data we have available. The goal is to show you the frequency and magnitude of an investment's good and bad performance periods.

To find a fund's rolling returns, click on the Chart tab on the page for an individual mutual fund. You'll be directed to the fund's Growth of $10,000 chart. Toggle over the Growth tab, and you'll get a dropdown menu. Select the Rolling Returns option. You'll then see the three-month rolling returns for the investment--how often it was in the black in various three-month periods as well as how often it posted negative returns.

Let's say you're looking at the three-month rolling returns for our previous example, Rydex Dynamic NASDAQ-100 2X Strategy, starting from Oct. 1, 2004 (the month after its inception). The first three-month rolling period would be Oct. 1, 2004-Jan. 1, 2005, followed by Nov. 1, 2004-Feb. 1, 2005, then Dec. 1, 2004-March 1, 2005, and so on. If you look at the rolling returns for this particular fund, you'll see that the fund's shareholders have endured many three-month periods in the red, interspersed with abrupt spikes in performance when the fund generated huge returns and also outpaced its peers by a huge margin. In short, the fund's near-term numbers look flashy, but its return history has been erratic. This isn't surprising, given that it's a leveraged Nasdaq 100-tracking fund.

Rather than looking at the rolling returns on a three-month basis (which is the default option), try switching the view to the 12-month rolling period for a look at how the fund did during a 12-month stretch of time. Even over longer periods, the fund looks quite volatile with many one-year periods of deep losses or radical outperformance. Click here to read more about the tool and other related features.

A fund's rolling-returns history also helps investors discern the appropriateness of an investment if they have a fairly short time horizon, by displaying the likelihood that their fund would be in a trough at the time they needed to withdraw their money. In the case of a short-term government bond fund such as  Vanguard Short-Term Federal (VBISX), the answer would be "not very." One look at this fund's rolling-returns graph explains why.

Although Vanguard Short-Term Federal has suffered small losses in the past three rolling three-month periods (albeit significantly less than its peers or the Barclays US Aggregate Bond Index), it has generally demonstrated remarkable consistency in producing positive returns. Switch the Rolling Period dropdown option from 3 months to 12 months, and the picture is even more reassuring. The fund was ever so slightly in the red in just a single one-year period time in the past decade--during the rolling 12-month period of April 2004 to April 2005.

Which Return Is Best?
So even though rolling returns, on many fronts, are more sensible and revealing measures of past volatility and performance than are trailing returns, they should not be an investor's sole focus. Narrowly homing in on the rolling returns of shorter time frames can cause an investor to lose sight of poor long-term trailing returns. Ultimately it's important for investors to consider both trailing and rolling returns--along with their time horizon and tolerance for volatility--in making their investment decisions.