Marketing Returns

Jim Lowell, Fidelity Investor, in a Forbes article, brings our attention to two possibly misleading practices in reporting performance numbers that can be used in Mutual Fund advertising campaigns:

  1. How fund returns are calculated.
  2. Who earned those returns.

1. Annualized Returns Don’t Tell the Whole Story

“Annualized” returns don’t tell the whole story on fund performance. In fact, they can mask the real story.

Flat Yet Soaring?Jim gives the example of 2005, a volatile year, and by the third quarter, returns were flat. Yet, looking at the chart below, several funds report being up. How can that be?

In times of high volatility, the performance numbers you see over a period of a few months can be very confusing when taken out of context. This can make the quarter-end rankings of mutual funds by their three-year, and sometimes five-year, numbers unreliable. Citing returns through the end of 2005’s third quarter focus on single-period returns, and lack context. Returns for the single 3-year period and single 5-year period ending in September 2005, can be very misleading.

The Greater Context – Compared to What?: The bear market virtually hit bottom at the end of September 2002, hitting a nadir in mid-October before rebounding for a positive return that month. Consequently, by the end of the third quarter, 2005, the 3-year returns ending September 2005 would be up compared to that dismal period, and that would make them look a bit too rosy.

By contrast, the 5-year numbers might look a little worse than they should, given that their starting point, the end of September 2000, saw the stock market just 6% below its March record high.

The table below shows (in red) spectacular looking annualized 3 year returns, while the five-year numbers mostly look dismal. The net result is that, ranking the funds by their 3-year returns, the ranking would look quite a bit different from the ranking based on 5-year returns.

However, look at the average 3-year and 5-year rolling returns for each of the funds in the list based on monthly performance going back 10 years (in blue.) Ranking the funds by these rolling return figures, youfind much greater consistency in relative fund performance.

One important reason is that the 3- and 5-year returns measure just two time periods, but the rolling returns measure more than 80 three-year and more than 50 five-year periods.

Annualized Returns Are Inconsistent, Rolling Returns More Consistent

Fidelity Fund 3-Year  Annualized % Return 5-year Annualized % Return 3-Year Rolling % Returns 5-Year Rolling % Returns
Aggressive Growth 17.1 -20.7 3.3 -2.4
Capital Appreciation 20.1 0.3 8.4 6.5
Contrafund 15.8 3 9.6 7.5
Value 20.4 14.4 9.2 9.1
Utilities 19 -4.6 4.8 1.5
Diversified International 21.2 6.3 9.8 8.5
Emerging Markets 27.5 8.5 -3.2 -3.8
Medical Delivery 23 21.3 6.6 8.4
Excerpted from the September 2005 issue of Jim Lowell’s Fidelity Investor . Click here for more of Lowell’s insights and analysis of Fidelity funds, and to subscribe to Fidelity Investor.

2. Manager Changes Aren’t Accounted For

Over the five years ending in 2005, there were more than 50 manager changes at Fidelity, and this is consistent with the average manager turnover rate in the fund industry.

Yet, rating agencies like Morningstar employ systems based on past fund performance rather than the individual manager’s performance history. So, even though the manager who may have been responsible for the actual performance of the product may no longer be running the fund, the funds may continue to use those ratings to promote their fund products.

Jim Lowell questions whether there might be an increase in manager turnover as many younger guns or experienced hands take the opportunity of their glowing short-term numbers to advance their careers by moving to a new fund family, or jumping from mutual funds to hedge funds, or from retail funds to institutional ones.

Bottom Line: Put 3- and 5-year “rankings” in perspective and read the fine print.

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