How to measure a mutual fund's performance.

Perhaps the question most frequently asked by mutual fund investors is: How is
a fund doing? That question is an essential one to consider before investing in
any fund, or when you review an existing investment portfolio to make sure its
on course toward meeting your financial goal.

Unfortunately, evaluating a fund's performance can't be done simply by
checking the investment returns of the fund, although that is a good starting
point. Instead, an investor should see how the fund's returns compare with
those of similar funds or with appropriate market indexes. Its also important to
consider whether the fund is suitable given the investor's financial objective and
time horizon (the length of time until you will need the money).

Two issues that are often overlooked involve costs and taxes. Costs can
significantly reduce earnings on a fund investment, while taxes reduce the
earnings that you are allowed to keep and different types of funds have very
different tax implications.


What Is Total Return?

To evaluate a mutual fund's investment performance, investors should start by
studying its total return. Simply put, total return is the sum of a fund's income
and capital returns after ongoing expenses are paid. A more precise definition
is that total return is the change in the value of an investment in a fund, taking
into account any change in the fund's share price during the period and
assuming the reinvestment of income dividends and capital gains distributions. A
fund's ongoing expenses are reported as an expense ratio annual expenses
as a percentage of average annual net assets.

The nature of total return varies greatly from one type of fund to another, but all
include one or both of the following components:

Income return. A mutual fund may produce current income from
investments in interest-bearing securities such as bonds or money market
instruments, or from dividends paid on common stocks owned by the
fund. Yield is the dividend and interest income that a fund pays over a
time period and it should not be confused with total return, which
includes any capital returns. 

Capital return. When the securities held by a mutual fund rise in
value or appreciate above the price at which they were purchased,
the fund has a positive capital return. This can create capital gains when
the fund sells the securities or when an investor sells fund shares.
Investments that can generate capital gains can also suffer capital losses if
the securities decline in price.

Understanding the components of a fund's total return can help you determine
whether that fund is appropriate given your investment goal, the amount of time
until you expect to sell the investment in the fund, your tolerance for investment
risk, and your financial condition. For instance, if you need current income,
select a fund (such as a money market or bond fund) whose total return comes
primarily from income rather than capital growth.


Total Return Is Reported Two Ways

Total return is commonly reported as an average annual percentage. An
investment that has an average annual return of 10% for five years will have
grown 61% across that entire period because of compounding (the 10% return
is earned on both the original principal and earnings from years two through
five).

Measuring Your Personal Returns

Shareholders sometimes ask why their personal returns (or the changes in the
value of a fund investment) don't always match the returns reported by the
mutual fund company for that fund. Here's why: In calculating total return, a fund
company assumes that dividend and capital gains distributions are all reinvested
and that there are no redemptions or other purchases during the period. If you do
not reinvest distributions, if you purchase or redeem shares during the period, or
if you do not hold the shares for the full period, then your personal return likely
will not match the fund’s reported total return for the period. 

Investors who would like to calculate their personal returns on portfolios may do
so with the help of personal finance software such as Quicken®. Of course, any
return figure must be compared with an appropriate benchmark to determine
whether the fund is providing superior or inferior performance. Unfortunately, its
not likely that there is a reliable benchmark for an individuals unique mix of
investments.


Put Performance in Perspective

Historical performance isn't a good predictor of future results, as Figure 4
demonstrates. Funds that ranked high in one year often performed poorly in
subsequent years. Over time, there's a tendency for once top-performing funds
to produce only average results. Investors should be careful to not chase the
latest hot fund based on performance during the most recent month, quarter,
or 1-, 5-, or 10-year period. Many top-performing funds achieved their
spectacular returns because of temporary market movements or because they
invested in narrow segments of the stock market. These hot investments
invariably cool off and are replaced by another group of short-term stars.

Don't Overlook a Fund's Risks

Focusing only on a fund's recent returns means an investor is ignoring the fund's
risk characteristics. An investor may be able to obtain higher long-term returns
by taking on additional, carefully considered risk. For instance, trying to avoid
risk by investing in a money market fund for a goal that is many years away
means that an investor is likely to receive lower long-term returns.

Some of the key risks that affect mutual funds are the following:

Market risk. The general prices of stocks and bonds can move up and
down dramatically. This risk may be reduced by holding an investment
for a long period, at least ten years, or by investing in more than one
asset class. 

Interest rate risk. Bond prices and some common-stock prices can
rise or fall because of changes in interest rates. When interest rates fall,
bond prices rise. Conversely, when interest rates rise, bond prices fall. 
Income risk. As interest rates change, so can the income provided by
money market and bond funds. 

Sector risk. If a fund's holdings are concentrated in a single industry, the
fund is less diversified than the broad stock market and may provide
lower returns than the market by a wide margin or for extended periods.

Of course, there are a number of other risks specific to particular types of
funds. You can find a discussion of the relevant risks in a fund's prospectus.

How to Measure Volatility

The net asset values (share prices) of stock and bond funds routinely fluctuate,
but some fluctuate more than others. This volatility is an important consideration
for investors, some of whom are better able to accept it because of their longer
time horizon, greater tolerance for risk, or stronger financial circumstances. The
following is a brief summary of some commonly used measures of historical
volatility, which some investors use to estimate a fund's potential riskiness.
These measures may change over time, as changes in a fund make it more or
less volatile.

Beta. A measure of how volatile a fund's past returns have been
compared with an appropriate market benchmark. By definition, the
benchmark's beta is 1. The returns of a fund with a high beta (more than
1) are expected to rise and fall more than those of the benchmark, while
one with a low beta (less than 1) is expected to be less volatile than the
benchmark. Of course, a fund's beta is based on its volatility for a given
past period, and that may change over time. One word of caution: A fund
may have a low beta in comparison with a market benchmark that is itself
extremely volatile. That means the value of the fund would also be
fluctuating considerably, though less so than the benchmark. 

Duration. An estimate of how much a bond fund's share price will rise or fall 
in response to a one-percentage-point change in interest rates. The share price 
of a bond fund declines when interest rates rise, and when interest rates
fall, the share price rises. A bond fund's average duration (expressed
in years) can be used to calculate how much the fund's share price will change 
in response to an increase or decrease in interest rates. The percentage change 
in the share price is equal to the duration multiplied by the percentage-point
change in interest rates. (If rates fall 0.5 percentage point and a fund has
a duration of 10 years, then the share price will rise about 5%.)  R-squared. A 
measure of how much a fund's past returns can be explained by the returns from 
the overall market (or its benchmark index). If a fund's total return were precisely 
synchronized with the overall market's return, its R-squared would be 1.00 (100%). 
If a fund's returns bore no relationship to the market's returns, its R-squared 
would be 0. The higher the R-squared, the more the fund's return is explained
by the market's performance. The lower the R-squared, the more the return is explained 
by the fund manager's decisions.

Don't Track Just the Share Price

Some investors monitor funds by checking the net asset value (share price)
listed in daily newspapers and other publications. But the net asset value can
provide a misleading picture of a fund's performance.

A fund's net asset value is reduced whenever a dividend or capital gains
distribution is paid. The amount of the reduction often differs from the change in
the net asset value on that day because of changes in the market price of the
securities held by the fund. For example, say a fund has a net asset value of
$10, and it pays a $0.10 dividend per share so the net asset value is reduced
by $0.10. But if the securities in the fund declined 1% in value that day ($0.10 a
share), then the total change would be $0.20, and the net asset value would be
$9.80—not the $9.90 that would reflect only the dividend payment.

Finally, share prices of stock and bond funds fluctuate almost every day, but you
need to keep those changes in perspective. For instance, a $1 drop in a $100
share price is a change of 1%, but a $1 decline in a $10 share price is a 10%
shift. 

Use the Proper Measuring Stick

Historical performance alone doesn't tell you whether a fund's returns are good
or bad. How well a fund has performed can better be determined by comparing
the fund's performance with the performance of an appropriate benchmark
during the same period. For instance, if a large-company stock fund returned
20% in 1998, some of its shareholders might have been pleased. After all, 20%
is nearly twice the long-term historical average return for the stock market as
represented by the S&P 500 Index. But that 20% return was well below the
S&P 500 Index's total return of 29% that year, so the fund would have
underperformed its benchmark.

Mutual fund performance can be gauged against two types of benchmarks or
measuring sticks' market indexes and peer group averages. An index tracks
the total return of all the securities (stocks or bonds) in the market or some
segment of the market. Peer group averages measure the average returns
achieved by a group of mutual funds with similar investment goals and policies.
Two of the best-known providers of peer group averages are Morningstar,
Inc., and Lipper Inc. The performance of major indexes and peer group
averages is reported regularly in financial publications such as The Wall Street
Journal.

Different market indexes are used as a basis of comparison for different types of
funds. The one that is most appropriate for a given fund is typically listed in the
fund’s prospectus and its annual report.

