Fund Performance Calculations
(TMF Sheard)
LEXINGTON, KY. (July 1, 1998) -- The Motley Fool has a long-standing axe to grind with the mutual fund industry; that's no secret. Over the long run, the vast majority (4 in 5) of actively managed stock mutual funds don't even keep pace with the Standard & Poor's 500 Index.
But I also have another axe to grind with the industry: their official returns aren't even that meaningful.
Mutual funds work on a unit value system, which means that they can sell an infinite number of shares, and at the end of each day they publish a Net Asset Value, the value of all the fund's assets divided by the current number of shares outstanding. Anyone buying into the fund will get shares valued at that day's Net Asset Value and the figures are updated again. It's a perfect way to keep track of ownership percentages when the fund has daily changes in cash flows.
The problem comes, however, when the unit value method is used to calculate the fund's returns. What a fund's official return really measures is only the growth of shares held since the first day of the year. It's an irrelevant figure for the shares purchased after that first date. Let me explain this with an example (an extreme example, it is true, but I maintain that if the calculation method doesn't work for extreme cases, it's worthless for ordinary ones, too).
An incubator mutual fund opens up with $1 million on January 1, let's say. (An incubator fund is one started with the company's own seed money. They manage a small amount carefully, recording a great return, and then pour on the marketing with the fund's returns and huge money pours in, never to see similar returns again.) The NAV is $10 per share, let's say, so there are 100,000 shares outstanding.
Six months later, the manager has doubled the portfolio, a great job. There are still 100,000 shares outstanding, but the NAV is now $20 per share.
Now word gets out that the new fund doubled in six months, and $200 million comes pouring into the fund at mid-year, all at $20 per share. Instead of $2 million in assets, now there's a total of $202 million, with 10,100,000 shares outstanding, at $20 each.
Now let's zoom to the end of the year. The portfolio's done nothing in the second half and there are still 10,100,000 shares at $20 each, a total portfolio of $202 million.
Now based on the unit value return method used by mutual funds, this fund will report an annual gain of 100%. The NAV started at $10 per share and ended the year at $20 a share. But that's completely false, I think you'll agree, as an accurate measure of the whole fund's performance over the course of the year. It accounts for neither the duration nor the size of the cash flows during the year.
A more accurate return would be recorded using an internal rate of return calculation, which accounts for both the size of the cash flows as well as their duration in the portfolio. Using these dates and cash flows, an internal rate of return spreadsheet would look like this:
Date Cash Flow Jan. 1, 1997 $1,000,000 Jul. 1, 1997 200,000,000 Jan. 1, 1998 ($202,000,000)
The final value in such a calculation is listed as a negative number, as if the whole account were being liquidated. (If you'd like a fuller explanation about how to set up internal rate of return calculations using Excel, please see my Foolish Four column from October 10, 1997.)
Instead of a 100% bogus return, pumped up with a relatively tiny amount of money early in the year, the whole portfolio really grew at an annualized rate of only 0.98%. For half the year, over $200 million was under management, but the entire profit for the year was only $1 million. The internal rate of return more accurately measures how the whole portfolio did, incorporating all the cash flows rather than measuring the unit value growth only of those shares in the portfolio the entire year.
Obviously, most mutual funds won't see a scenario like this one, with wildly skewed cash flows. Even so, the internal rate of return is a better indication of how funds perform than is the unit value method adopted by the industry. Just one more thing to raise your eyebrows about Foolishly!
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[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]