Fund's performance: Meaning, Criticisms & Real-World Uses

What Is Fund's Performance?

Fund's performance refers to the investment return generated by an investment fund over a specific period, reflecting how effectively its assets have grown or depreciated. This crucial metric falls under the broader discipline of investment management, providing a quantitative measure of a fund's success relative to its objectives and market conditions. Investors, analysts, and regulators closely examine fund's performance to assess a portfolio manager's skill, evaluate investment strategies, and make informed decisions. It is typically expressed as a percentage change in the fund's Net Asset Value (NAV), accounting for income and capital gains, and is a key indicator of a mutual funds ability to achieve its stated goals.

History and Origin

The concept of measuring investment performance has evolved significantly alongside the growth of financial markets and the increasing sophistication of investment vehicles. Early forms of performance tracking were rudimentary, often simply comparing current value to initial capital. However, with the rise of institutional investing and the development of modern portfolio theory in the mid-20th century, a more rigorous approach to evaluating fund's performance became essential.

Pioneering work by academics like Harry Markowitz, William Sharpe, Jack Treynor, and Michael Jensen laid the groundwork for quantitative performance measurement. Their research introduced concepts such as risk-adjusted return, leading to metrics like the Sharpe Ratio and Jensen's Alpha, which are still widely used today¹⁹, ²⁰. These methodologies allowed for a more nuanced understanding of how returns were generated, differentiating between returns earned from simply taking on market risk versus those derived from manager skill. The formalization of these measurement techniques became critical for the nascent mutual fund industry, enabling investors to compare funds more accurately and understand the true value added by professional management. Academic literature has extensively surveyed the evolution of these performance measurement techniques for traditional investments.¹⁸

Key Takeaways

Fund's performance measures the percentage change in an investment fund's value over a period.
It is typically calculated using the Time-Weighted Rate of Return, which removes the impact of investor cash flows.
Regulatory bodies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) impose strict rules on how fund performance is reported and advertised.
Analyzing fund's performance often involves comparing it to a relevant benchmark and adjusting for risk.
While essential, past fund's performance is not indicative of future results and should be considered alongside other factors.

Formula and Calculation

The most common and preferred method for calculating fund's performance for reporting purposes is the Time-Weighted Rate of Return (TWRR). This method removes the distorting effects of cash inflows and outflows (such as new investments or withdrawals by shareholders), providing a truer measure of the portfolio manager's skill in managing the assets under their control.

The Time-Weighted Rate of Return calculates the geometric mean of a series of holding period returns. For multiple sub-periods, the formula is:

TWRR = [(1 + HP_1) \times (1 + HP_2) \times ... \times (1 + HP_n)] - 1

Where:

(TWRR) = Time-Weighted Rate of Return
(HP_i) = Holding Period Return for sub-period (i)
(n) = Number of sub-periods

The Holding Period Return for each sub-period is calculated as:

HP = \frac{EMV - BMV - CF}{BMV}

Where:

(EMV) = Ending Market Value
(BMV) = Beginning Market Value
(CF) = Cash Flow during the period (positive for outflow, negative for inflow)

By linking individual sub-period returns, the TWRR effectively assumes that any cash flows occur just before a new sub-period begins, thereby neutralizing their impact on the overall performance calculation. This contrasts with the Dollar-Weighted Rate of Return, which is influenced by the timing and size of cash flows.

Interpreting the Fund's Performance

Interpreting fund's performance requires more than just looking at a raw percentage return. A fund's return should always be evaluated in context, considering its investment objectives, the level of risk taken, and comparison against an appropriate benchmark.

For instance, a fund that generated a 10% return might seem excellent until it's revealed that its benchmark index returned 15% over the same period, suggesting underperformance. Conversely, a 5% return might be commendable if the market experienced a significant downturn, indicating strong capital preservation. Metrics like alpha and beta, derived from models like the Capital Asset Pricing Model (CAPM), help investors understand the fund's return relative to its systematic risk. Investors should also consider the fund's expense ratio, as high fees can significantly erode net returns over time.

Hypothetical Example

Consider a hypothetical growth fund, "DiversiGrowth Fund," with an initial NAV of $10.00 per share at the beginning of the year.

Quarter 1: The fund experiences strong market gains, and its NAV increases to $11.50. No cash flows occur.
- HP1 = (($11.50 - $10.00 - 0)) / $10.00 = 0.15 or 15%
Quarter 2: The market pulls back, and the NAV drops to $10.80. Investors collectively withdraw $0.50 per share (due to distributions or redemptions). The effective ending NAV for calculation purposes, before the cash flow, would have been $10.80 + $0.50 = $11.30.
- HP2 = (($10.80 - $11.50 - (-$0.50))) / $11.50 = (($10.80 - $11.50 + $0.50)) / $11.50 = (($-0.20)) / $11.50 = -0.01739 or -1.74% (approximately)
Quarter 3: The market recovers, and the NAV rises to $12.00. No cash flows.
- HP3 = (($12.00 - $10.80 - 0)) / $10.80 = 0.1111 or 11.11%
Quarter 4: The NAV closes the year at $12.50. No cash flows.
- HP4 = (($12.50 - $12.00 - 0)) / $12.00 = 0.04167 or 4.17%

To calculate the annual Time-Weighted Rate of Return:

TWRR = [(1 + 0.15) \times (1 - 0.0174) \times (1 + 0.1111) \times (1 + 0.0417)] - 1

TWRR = [1.15 \times 0.9826 \times 1.1111 \times 1.0417] - 1

TWRR \approx [1.3218] - 1 \approx 0.3218 \text{ or } 32.18\%

This calculation shows that despite an interim withdrawal, the underlying investment decisions led to a positive fund's performance of approximately 32.18% for the year. This approach isolates the performance of the fund's holdings from the timing of investor capital movements, providing a clear picture of the portfolio management's effectiveness.

Practical Applications

Fund's performance is a cornerstone of the investment industry, permeating various aspects of finance:

Investment Selection: Investors rely on historical fund's performance data, alongside other factors like the expense ratio and investment strategy, to select funds that align with their financial goals and risk tolerance. While past performance does not guarantee future results, it offers insights into consistency and management style.
Regulatory Reporting: Regulatory bodies, such as the SEC in the United States, mandate strict reporting requirements for registered investment companies regarding their performance. These regulations ensure transparency and protect investors by providing standardized data. For example, registered investment companies must file periodic reports with the SEC, including annual reports on Form 10-K and quarterly reports on Form 10-Q, which provide comprehensive summaries of a company's performance and financial health.¹⁷ The SEC also requires mutual funds to disclose expenses borne by shareholders and present portfolio holdings in a tabular or graphic format in their reports.¹⁵, ¹⁶ The SEC regularly publishes data and analysis on registered investment companies, highlighting key statistics and trends.¹³, ¹⁴
Marketing and Sales: Fund companies utilize fund's performance figures in their marketing materials to attract new investors. However, these communications are heavily regulated by entities like FINRA to prevent misleading claims. FINRA Rule 2210 generally governs communications with the public, and historically, presenting related performance information in public communications about mutual funds was seen as inconsistent with content standards. However, in 2015, FINRA allowed certain types of related performance information to be included in communications with institutional investors under specific conditions, such as clear labeling and prominent display of the fund's actual performance if it exists for more than one year.¹⁰, ¹¹, ¹² Recent proposals also aim to allow performance projections and target returns in communications with qualified purchasers and institutional investors.⁹
Performance Attribution: Advanced analysis delves into the sources of fund's performance, breaking down returns into components attributable to asset allocation, sector selection, or individual security picking. This helps portfolio managers understand what drove their returns and refine their strategies.
Compensation and Incentives: The compensation of portfolio managers is often directly tied to the fund's performance relative to its benchmark or peer group.

Limitations and Criticisms

While fundamental, fund's performance has several limitations and criticisms:

Past Performance is Not Indicative of Future Results: This ubiquitous disclaimer is crucial. Market conditions change, management teams can turn over, and a fund's past success offers no guarantee of its future performance. Over-reliance on historical returns can lead to poor investment decisions, such as performance chasing.
Behavioral Gap: The reported fund's performance (time-weighted return) often differs significantly from the actual returns experienced by individual investors. This "behavioral gap" or "investor return" (dollar-weighted return) occurs because investors frequently buy into funds after periods of strong performance (buying high) and sell after poor performance (selling low), thereby undermining their personal returns relative to the fund's overall track record. Morningstar research highlights this gap, noting that investor returns can lag total returns due to the timing of cash inflows and outflows⁶, ⁷, ⁸.
Benchmark Selection: Choosing an appropriate benchmark is critical. An irrelevant benchmark can make a fund appear to perform well or poorly without truly reflecting its investment universe or strategy.
Risk vs. Return: High returns might simply be a consequence of taking on excessive risk. Without considering risk metrics like standard deviation or Sharpe ratio, fund's performance can be misleading. A fund with lower returns but significantly lower risk might be preferable for many investors.
Window Dressing and Portfolio Pumping: Fund managers might engage in practices like "window dressing" (buying popular stocks at quarter-end to appear to have owned them during their rally) or "portfolio pumping" (buying shares of stocks the fund already owns to inflate their price and thereby the fund's performance) to artificially enhance reported fund's performance⁵. Regulatory bodies attempt to monitor and curb such activities.

Fund's Performance vs. Investor Return

While often used interchangeably by the general public, "fund's performance" and "investor return" represent distinct concepts, particularly within the realm of portfolio evaluation.

Fund's performance, often referred to as "total return" or "time-weighted return," measures the rate of return of the underlying investments within the fund, independent of any money flowing into or out of the fund. It reflects the skill of the portfolio manager and the effectiveness of the fund's investment strategy, assuming a single lump-sum investment held for the entire period. This is the standard metric used for comparing funds and is typically what is quoted in official fund reports and marketing materials.

In contrast, investor return, also known as "dollar-weighted return" or "internal rate of return," measures the actual return experienced by the average investor in the fund. This calculation takes into account the timing and size of individual investor contributions and withdrawals. For example, if an investor consistently puts more money into a fund after its best performance periods and withdraws money during its worst, their personal investor return will likely be lower than the fund's overall reported performance. Morningstar has conducted extensive research on this "behavior gap," illustrating how investor behavior can lead to a significant difference between the two figures.², ³, ⁴

Feature	Fund's Performance (Time-Weighted Return)	Investor Return (Dollar-Weighted Return)
Purpose	Measures manager's skill; fund's investment success	Measures actual return experienced by the investor
Cash Flow Impact	Eliminates impact of investor cash flows	Incorporates timing and size of investor cash flows
Standard Use	Industry standard for fund comparison, reporting	Reflects individual investor behavior

FAQs

Q1: How often is fund's performance calculated and reported?

A fund's performance is typically calculated daily based on its Net Asset Value (NAV). For reporting to investors and regulatory bodies, it is commonly presented for various periods, such as one-month, three-month, year-to-date, one-year, three-year, five-year, ten-year, and since inception. The SEC requires registered management investment companies to transmit reports to shareholders semi-annually and file them with the Commission.¹

Q2: What is a "good" fund's performance?

"Good" fund's performance is subjective and depends on several factors. It generally means the fund has met or exceeded its stated investment objectives and outperformed its relevant benchmark or peer group over a consistent period, while taking an appropriate level of risk. A fund with strong risk-adjusted return metrics is often considered to have good performance, as it demonstrates efficient use of risk to generate returns.

Q3: Why is past fund's performance not a guarantee of future results?

Past fund's performance is based on historical market conditions, economic environments, and the fund manager's past decisions. Future market conditions are unpredictable, and various factors, including changes in economic cycles, interest rates, company-specific events, and shifts in investment strategies or management teams, can affect future returns. This is why investors are always cautioned that past performance cannot predict future outcomes.

Q4: How do fees impact fund's performance?

Fees, such as the expense ratio, management fees, and trading costs, directly reduce a fund's net return. A fund that generates a 10% gross return but has an expense ratio of 1.5% will only deliver an 8.5% net return to investors. Over long periods, even small differences in fees can significantly impact the compounding of returns and, thus, the overall fund's performance experienced by an investor.

Q5: Can fund's performance be negative?

Yes, fund's performance can be negative, meaning the fund has lost value over the measurement period. This can occur due to market downturns, poor investment decisions, or adverse economic conditions. Investors should be prepared for the possibility of negative returns, especially with equity funds or other volatile asset classes, and consider their overall diversification strategy to mitigate such risks.