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Evaluating Mutual Fund Performance

Money Manager | Monday, November 29th, 2010

Evaluating the performance of a mutual fund can sometimes be a bit confusing, especially if you are new to investing. Mutual funds often advertise high rates of return, but many times this only highlights a particularly good year. If you take a closer look, the same mutual fund may have had much lower return rates in previous years, or may have even lost money during one or more years. When buying a mutual fund, it’s important to take a broader view of the fund’s overall performance, so that you can better gauge what it’s results may be in the future. Of course, even looking at past performance is no guarantee of future performance.

Comparing Against the Benchmark Index

When comparing the performance of an individual mutual fund, it’s also important to compare it against a benchmark. There are numerous indexes in the financial field that experts use to gauge an investment’s performance, including the Dow Jones Industrial Average and the S&P 500. When evaluating performance, you should look at these broad market indexes as well as the bond and stock indexes for the market segments that are relevant to the mutual fund. For example, even if a mutual fund produced a 50% return, it’s not good news if the index had a return of 70% for the same time period. On the other hand, even a 20% return looks good if the index had a return of 15%.

Comparing Against Other Mutual Funds

Besides comparing a fund against the indexes, it’s also important to compare it against its peers. If a particular mutual fund outperforms other comparable funds, then it’s probably a solid investment, especially if it also outperformed the benchmark index. On the other hand, if a fund is listed near the bottom of a fund comparison chart, it’s probably a questionable investment. It’s also important to understand that mutual fund companies regularly close their least impressive performers, which tends to make category averages appear higher than they would if the poor performers were still averaged in. Looking at as many data points as possible is generally the best course of action when choosing a mutual fund. Not only will this help you better assess past performance, but it should also help you predict possible future performance with a better degree of accuracy. However, it’s important to remember that even the best fund will have a low performing year or two occasionally, sometimes due to overall economic conditions or specific circumstances in its market segment.

Other Factors to Consider

In addition to comparing a fund’s return rate against benchmark indexes and its peers, it’s also a good idea to look at the performance of the money manager. Be sure to factor management fees into the equation, since high costs will definitely cut into your return. You should clearly understand the tax implications of investing in a fund, since the tax burden can vary depending on the fund. A good understanding of the mutual fund is also important. For example, although a certain fund may have a high return, it may also carry a risk that is too high to justify your investment. On the other hand, an extremely safe fund may have too low of a return to allow you to meet your financial goal.

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