You’d think that if a mutual fund reported a 3-year return of over 24% per year, most of its investors would be quite happy. After all, any money kept in the fund over those 3 years would nearly double. Looks can be deceiving. Reported returns aren’t enough information to tell how the investors have fared.
Suppose that ABC Explosive Growth Fund starts out with $10 million of investors’ money. To simplify our example, we’ll only allow money to enter or leave the fund at the start of each year. After one year, another $10 million of new investor money enters the fund. After another year, investors pour an additional $60 million into the fund.
After the end of the third year, suppose that ABC fund holds $80 million. Note that this exactly equals the total amount of money contributed to the fund ($10 million twice and then $60 million). So ABC generated zero net return over those 3 years. Does this mean that their reported 3-year return will be 0%?
Nope. In coming up with this 0% figure, we have calculated what is called the internal rate of return. But this isn’t how mutual funds calculate returns. To work out ABC’s reported 3-year return we need a little more information. Here is some more detail for our example:
Year 1: ABC grows $10 million into $15 million (50% return).
Start of year 2: Investors add $10 million. The fund now holds $25 million.
Year 2: ABC grows $25 million into $40 million (60% return).
Start of year 3: Investors add $60 million. The fund now holds $100 million.
Year 3: ABC has a bad year and loses $20 million (-20% return).
The average compound return of the 50%, 60%, and -20% one-year returns is a little over 24% per year. But, the other method told us that the return was zero. How could the two ways of working out the 3-year return be so different?
The answer comes down to what type of investor you have in mind. If you think of the investor who leaves his money in the fund for the whole 3 years, then you get the 24% figure. However, in our ABC example, very little of the money in the fund was invested this way. If you think of the actual average experience of investors in the fund, then you come up with the 0% return.
Essentially, the way that funds report their returns ignores the total assets of the fund. My example is extreme, but the internal rate of return method that takes into account the actual experience of investors usually gives lower returns than those reported by mutual funds. This is because funds tend to perform better while they are small. As funds get bigger, the managers often run out of good ideas for investing the new money. This isn’t true of all funds, but it does happen with many of them.
All of this begs the question of which method mutual funds should use for reporting their returns. There are advantages and disadvantages to both methods. My preference would be to require that both types of return be reported. This might be confusing, but potential investors would be right to be concerned if the two returns were significantly different.