The Determinants of Mutual Fund Performance

According to 2010 U.S. census data, there were nearly 7,600 mutual funds with $11.8 trillion in assets. As an investment vehicle, a mutual fund provides the benefit of affordable access to a professionally managed and diversified portfolio of securities. When choosing one to invest in, you should consider key factors that determine a mutual fund's performance: category, style or sector focus, manager skill, if it's actively managed, and the fee structure.

Mutual Fund Categories

Mutual funds pool money from investors, then invest in one or more of the traditional asset classes: stocks, bonds or cash. Several passively managed funds are designed to simply provide exposure to an asset class or subclass such as a particular industry sector. The idea is to minimize tracking error relative to a benchmark. If the S&P; 500 index is the benchmark, the return of the fund should closely match the S&P; 500's return for any particular time period. The returns from a passively managed mutual fund invested in the same stocks represented by the S&P; 5000 index will essentially mirror movements in the index. A number of studies have focused on separating the returns of portfolios into components from long-run strategic asset allocation and active management decisions such as security selection and market timing. There is broad agreement that long-term asset allocation, that is how a portfolio is allocated across asset classes, is the primary determinant of portfolio returns.

Mutual Fund Styles and Sectors

Each mutual fund category consists of several style classifications, which are generally reflected in the fund’s name. Within stocks, for example, two opposing styles are value and growth. Value funds invest in stocks that have certain characteristics. For example, low price/earnings ratios might indicate stocks are undervalued and are associated with solid returns over the long term. Growth funds invest in stocks with characteristics that are associated with faster, short-term growth, such as low dividend yields. The relative returns of growth versus value stocks depend on the overall market environment and point in the business cycle. This is also true for other styles and sector funds that focus on particular industries.

Manager Skill

Actively managed funds, in contrast to passively managed funds, attempt to beat a benchmark. Positive excess returns, defined as the portion of a fund’s return that is higher than the manager’s benchmark, can theoretically be attained on a consistent basis if the manager is skilled at selecting securities, rotating sectors or timing markets. Some research indicates that any positive excess returns are, more often than not, just enough to cover the cost of the management fees.

Fees, Loads and Taxes

Sometimes superior manager skill (better research and information processing) warrants paying higher fees. However, particularly for passively managed funds, it is often in the investor’s best interest to find funds with the lowest fees. Fees may be one-time payments or ongoing, and sales charges may occur up front (front-end loads) or when investment is exited (back-end loads). Additionally, different funds may have various tax implications, which can impact total returns. Within the same fund, different fund classes usually have different fee structures. Often, the optimal fee structure is dependent on the investor’s time horizon (how long the investor plans to remain invested in the fund). The Financial Industry Regulatory Authority website offers a useful tool for analyzing the impact of different fee structures.

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About the Author

Kathryn Christopher has been writing about investments for more than 20 years. Her work has appeared in the "Journal of Alternative Investments" and numerous other academic and industry publications. She works at Wiggin Financial Planning, teaches for UMASSOnline from South Florida, and holds a PhD in finance from the University of Massachusetts.

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