Total Return

When determining a mutual fund's performance, total return is generally the best measure. Total return is derived by finding the percentage change in a fund's net asset value (NAV) over a specific period of time.

To calculate total return, the income dividends, capital gains and the change in NAV is divided by the NAV at the start of the period:

Income dividends are interest the fund earns or the dividends paid on its common stock.

Capital gains include the gain a fund earns when it sells a security.

Change in NAV (or share price) is the daily computation of the closing price of all the securities owned plus the value of all other assets minus liabilities, and dividing the result by the number of shares outstanding.

Total return is a useful tool for making "apples-to-apples" comparisons between the performances of two funds or a fund and its appropriate benchmark index. But it is important to remember that past performance does not predict future results.

Total return is reported as either average annual total return or cumulative total return. Average annual total return shows the average annual profit or loss realized by your investment over a specified time period. Cumulative total return shows the total profit or loss realized by your investment over a specified time period.

Average annual total return is more often used and is generally considered more reliable, whereas cumulative total returns are very difficult to compare.

It is important to note that neither total return calculation will indicate a mutual fund's volatility, and both are based on past performance, so future results may differ.

One of the most common errors investors make lies in the difference between yield and total return. Yield measures the current income (dividends or interest) produced by a fund, expressed as a percentage of the fund's net asset value. Generally, yield is based on income earned over the past 30 days and projected forward for the coming year.

Yield does not include any capital gains distributions and does not reflect the fluctuation of a fund's NAV—which sometimes accounts for much of a fund's total return.

Dividend and capital gains distributions are key components of total return. But total return also includes changes in NAV (appreciation or depreciation). Funds vary in how much of their total return derives from distributions and in how much comes from changes in NAV.

How a fund's total return is apportioned can have important tax consequences. In a taxable account, most fund distributions are taxable, even if you reinvest them. But you are not taxed on share price appreciation or depreciation until you sell your shares.

Another condition that also confuses investors occurs when the total return that they receive from a mutual fund investment does not exactly match the total return reported by the company.

Differences between the two figures can be caused by investors spending dividend and capital gains rather than reinvesting them, the purchase or selling of shares or investing in the fund after the start of the measuring period, or selling shares before the end of the period
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Costs

Mutual fund costs fall into two main categories: sales charges (known as "loads") and operating expenses. Not all funds impose loads, but all do have operating costs that are deducted from fund earnings.

Loads may be added to your account as either front-end, back-end or level.

A front-end load is charged when you purchase fund shares. Front-end loads also may be charged on reinvested distributions.

Back-end loads are charged when shares are sold. They are generally calculated based on how long the shares have been held.

Level loads are deducted annually from fund assets as marketing and distribution costs. These loads are used to pay commissions to brokers and the fund's financial advisor; they are generally reported as part of a fund's operating expenses.

Funds that have no sales charges are known as "no-load," while funds that charge loads of 1 percent to 3 percent are called "low-load."

Basic operating expenses include investment advisory fees, legal and accounting services, printing, telephone service, postage and other administrative costs. Operating expenses are usually deducted from a fund's earnings and are expressed as a percentage of a fund's average net assets.

In addition to loads and operating expenses, some companies charge other fees such as:

Exchange fee - Accrued when shares are sold and the proceeds used to buy shares of another fund in the same fund family.

Maintenance fee - Quarterly or annual charges used to offset the costs of maintaining small accounts.

Transaction fee - Charged whenever shares are bought or sold. They are used to help offset the cost of buying and selling securities.

Mutual funds are required to disclose all fees and expenses in the front of their prospectus. But you should not base any investment decision on cost alone. As with any investment, your purchase decision should be based on a number of factors, including your ultimate goals and risk tolerance.

The best way to determine and compare mutual fund costs is to consult the prospectus. The Securities and Exchange Commission (SEC) requires funds to disclose all fees and expenses in a table that appears at the front of the prospectus. This table includes all expenses that a hypothetical investor would pay on a $10,000 investment at the end of one, three, five and 10 years.
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The Role of Benchmarks

Benchmarks can be a valuable tool in helping to determine how well a mutual fund has performed.

Two types of benchmarks are commonly used:

• Market Index. Tracks the total returns of all the securities in the market or a segment of the market.

• Peer Group Average. Measures the average returns of a group of funds with similar investment goals and policies.

Using Benchmarks

Investors use benchmarks to measure fund performance and volatility.

To gain information about a fund's performance, one can look to the benchmark used for comparison in the prospectus and compare total returns over identical periods.

To gauge a fund's potential risk, many look to the 10-year performance of its benchmark index. Comparing the average annual total return with the largest one-year gain and largest one-year loss will generate an approximate measure of the fund's volatility.
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Tools for Measuring Performance

Because of the great public interest in mutual funds and the importance of accurate information, the Securities and Exchange Commission (SEC) requires mutual fund companies to publish a prospectus and two reports (an annual and a semiannual) for each fund.

A fund's prospectus is probably the best single source of information available to a potential investor. Within every prospectus is a financial table, usually located near the front. This table reports the fund's per-share financial results over the past decade—or since the fund's inception (for funds in existence less than 10 years). When you compare the performance of one fund with another, keep in mind that the data are presented on a fiscal-year basis, not by calendar year, and the fiscal-year period may vary from fund to fund.

The financial table can provide information on a fund's volatility, income return and costs. It can also be a valuable source of information on a fund's taxable nature.

Another source of information is the fee table, which lists the fund's operating expenses and any sales loads or fees. These shareholder expenses directly or indirectly affect your total return from your investment.

The semiannual and annual fund reports compare the fund's long-term performance with the performance of a relevant benchmark index. It may also include the average performance of peer group competitor funds with similar objectives and policies. These comparative data are very important in determining a fund's performance.

Many fund reports include comments or explanations from the fund's sponsor or manager. This commentary is often used to provide details as to why a fund did better or worse than its projections.

Another source of information to investors comes from the independent rating services. These companies rank mutual funds based on total return, risk and other factors.

Morningstar, Inc. - Ranks risk-adjusted performance over three, five and 10 years in four categories—domestic stock, international stock, taxable bonds and municipal bonds. Each fund is graded and given from one to five stars, with the top funds awarded five stars.

Value Line, Inc. - Ranks overall risk-adjusted performance in three categories—equity and partial-equity funds, taxable fixed-income funds and municipal bond funds, based on one-, three- and five-year data. Each fund is ranked from "one" (best) to "five" (worst). The top 10 percent of funds in each category are ranked "one."

Lipper Inc. - Uses more than 20 categories to rank funds, according to capitalization and risk level. Lipper Inc. bases its rankings on a wide range of criteria requested by clients in the financial services industry.

Standard & Poor's Corporation - Classifies funds by investment style, or "sector," and designates the top-ranked funds in each sector as "select funds." These select funds must rank in the top one-third of their sector in three-year performance and must have achieved those returns with a consistent investment style.

Ratings from one of these companies can be a good starting point in your search for a fund. But be sure to read the research report that explains the rating, and remember that ratings alone are not enough to make an informed investment decision.

Another good source of free information can be found through the financial media.

Most daily newspapers include mutual fund quotations, including net asset value, change in net asset value from the previous trading day, and year-to-date total return.

Funds are usually listed alphabetically by fund family, and listings may include symbols that denote fees, dividend or capital gains distributions, or other information. Some common examples of symbols found in newspaper listings include:

Magazines have also become a source for in-depth and quality information. In recent years, the number of financial magazines has grown and the information they distribute has become very important to many investors.

Some of the best known include Kiplinger's Personal Finance Magazine , Money , Mutual Fund Magazine , and SmartMoney . Business magazines such as Business Week , Forbes and Fortune also routinely cover mutual funds. Forbes , Money and Consumer Reports are among the magazines that publish annual editions devoted to mutual fund rankings.

Another source of information available to investors is newsletters. These publications can feature news about single funds, a family of funds or more general information. Many are created by money management firms with a product to sell, and therefore the information they offer could be self-serving.
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