People who invest in mutual funds naturally want to make their investment pay off. Of course, one way to do that is to find funds that have performed well in the past, and hope they do well in the future. As a general rule, mutual funds with the best returns from year to year are those that keep their costs down. It is quite natural to believe that mutual funds with lower costs are more desirable. You are trying to maximize the annual return on your investment. But what exactly is the “annual return”?
Let’s get a little background on mutual funds and their expenses first. A while back Harvard did a study involving undergraduates. These students had to choose between four similar mutual funds with different fees. Most of the students did not pick the least expensive mutual fund. Most of these mutual funds were performing well. Consequently, paying as much as two percent in expenses did not seem like much. But over the years it is amazing how this seemly little bits can add up to large sums.
A return on an investment is a measurement of how much the value of the investment has increased or decreased during a certain amount of time. The annual return for a mutual fund is a statement that tells an investor how much the fund has made or lost in the previous year.For example, if you were to invest a thousand dollars at the beginning of the year, and it was subsequently worth $1,100 at the end of the year – you would see an annual return of 10%. This number must take in to account all the expenses related to running the fund. If fees are 2%, your annual return in the above example would only be 8%. Again, that doesn’t sound like much, but it adds up. Additionally, you must also figure in inflation. If inflation is running 4%, you must make that amount in your annual return to break even. Inflation can eat in to annual returns quite quickly, especially if you have a low return.
There is another factor in calculating annual returns, especially over a long period of time. This is the issue of compounding. Compounding means that in addition to earning on the original investment, you also make money on the money you previously earned. Make sense? The compound average annual return – which is often advertised by mutual fund managers – gives the total return the fund has earned over a long period of time. This number accounts for all gains and losses, plus dividends. The number is expressed as a yearly growth percentage.It is important to understand that many of these annual return numbers are averages over a long period of time. Mutual funds often advertise a three year compound average annual return – let’s say 15% for example. This doesn’t mean that they actually earned 15% in any of the three years. They could have lost money in the first two years included in that average, and made it all back, plus more, in the third year. Only investors who owned shares during the up period of that three year span would have made money.Annual return is not a hard concept to understand. It is essentially just the amount the fund has earned in a year, after costs. They do like to play with the numbers sometimes to make themselves look better, so use caution when analyzing return data and make investment decisions after doing a good amount of homework.