Mutual funds are one of the best vehicles for long-term financial planning due to the different asset classes that they can hold and the high level of diversification that they provide their investors. Investors typically look at the historical performance of a fund before investing in it. But, what does the performance report of a mutual fund include, and are dividends included in it?
Mutual fund performance includes dividends if the total return is published for a stock-based fund. Total return calculations take the dividend paid out per unit of stock into consideration to ascertain the true performance of the fund. This helps investors compare performance to benchmark faster.
Understanding how to evaluate the performance of a mutual fund lets you know if you should choose the fund based on your investment goals or should look elsewhere. In this article, I’ll look at everything you need to know about measuring and understanding a fund’s performance.
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How Is Mutual Fund Performance Calculated?
There are three main approaches to calculating mutual fund performance. They include the following:
Absolute Return
Aka point-to-point return, this approach measures the return an asset generates over a specified period. It also calculates the depreciation or the appreciation level an asset like a mutual fund achieves over a time window. Then, it expresses the result in percentage.
The returns can be negative or positive, and there’s no comparison to a benchmark or other measures. It’s one of the easiest methods for calculating a mutual fund’s performance. The calculation considers the Net Assets Value (NAV) at the start of the investment and at the end of the holding period.
Dividing the absolute change in NAV by the start date NAV will give you the absolute return value. For example, if you buy into a mutual fund with the NAV at $100 per unit and sell after five years when the NAV totals $185, the absolute return on the fund would be 85%.
Absolute return is popularly applied when measuring all kinds of funds. However, the formula doesn’t give a true picture of performance when dividends are also paid out over the investment’s lifetime. In this situation, it’s best to use the measurement I’ll talk about next.
Total Return
This is the complete rate of return on any investment over a specific period. The total return is more reliable for calculating performance for stock-based mutual funds because it calculates dividends, distributions, capital gains, and interests realized over a timeframe.
It covers two variants of return:
- Capital appreciation: It measures the difference in the quoted price of any asset.
- Income: It calculates the interest paid by fixed-income investments, dividends, and distributions.
Basically, total return refers to the level of profits (or losses) you can earn from a fund over a fixed time frame assuming all dividends are reinvested. It’s a good measure of a mutual fund’s performance because it covers every factor contributing to an asset return, including capital gains, coupons, and distribution of dividends.
This is important because some types of assets—for instance, dividend stocks—typically deliver small capital gains due to their limited growth potential. Focusing on capital gains when measuring the investment’s return doesn’t take other methods through which a stock’s valuation can rise into account.
Think of a scenario where the share price of a stock rose by 34.2% within a year. Investors in a mutual fund based on this stock alone will gain 34.2% as returns based on market quote change alone. However, if the stock also paid 5.3% in dividends over this period, the real (or total) return will be 39.5%.
So, total return is the best way to measure an investment’s real growth over a specific period. It’s also an important metric used to analyze a fund’s historical performance.
To calculate the total return for a mutual fund, add the absolute change in NAV to the dividends distributed during the holding period and divide the sum by the NAV on the starting date of the fund. If you bought into the fund two years at a NAV of $10 per unit and sold it at $16 after the fund declared a dividend of $2.3 per unit for the period under review, the total return will amount to 83%.
Compound Annual Growth Rate (CAGR)
The compound Annual Growth Rate (CAGR) measures the annual growth rate of an investment over a certain period, incorporating the effect of compounding into the calculations. It’s typically used to measure the past performance of investments and to estimate future returns.
However, it’s only useful when the holding period is at least more than one year. It smooths off the effect of short-term volatility on any fund’s NAV. A mutual fund with a 4-year CAGR of 40% shows that the investment has grown at an average rate of 40% in the past four years.
You can find the formula for calculating CAGR as follows:
CAGR = [(Ending Value / Beginning Value) ^ (1 / Number of Years)] – 1
Which One Is Best for Measuring Performance on a Dividend-Paying Mutual Fund?
Looking at all I’ve covered so far, the total return is the best performance measure for all dividend-paying mutual funds. However, if you intend to hold the mutual fund for the long term, it’s best to use the CAGR to get a projection of the returns you probably get across the years.
A mutual fund with a total return of 30% in the last year may not be the best over the 6-7 years when you look at the CAGR. It could work out at less than 8% per year over that time. I’m sure most people grab that offer with both hands if it’s guaranteed, but it’s nice to have clear expectations before you invest.
Fortunately, you won’t need to do any of these calculations yourself, as many mutual funds will provide all the numbers up front. Where that’s not readily provided, go for a brochure or ask more questions.
What’s the Perfect Mutual Fund Return for a Year?
The perfect mutual fund return for a year is subjective. Individual investors will have different expectations and workable scenarios. Some investors will be happy with anything close to the average market return of 10% per year, while others will want much higher returns.
For the former group, any year where the mutual fund beats the market’s performance is a good year—even if it ended in the red. For investors in the latter group, negative years will be a disappointment.
If you’re in the second group, you should talk to your financial advisor for other investment opportunities that can beat the market consistently. That’s not to say no mutual funds can beat the market comprehensively once in a while. However, recent evidence shows that such results aren’t sustainable over the long run. Most mutual funds don’t beat the market.
It’s no surprise that many investors stick with mutual funds that track an index like the S&P 500 or similar. The returns will be higher or lower than the average 10% more often than not, but it’ll balance out over the medium to long term, delivering impressive compounded returns.
So, there’s no universal perfect yearly return for a mutual fund. It’s down to you to work out your investment goals and invest in a fund that best aligns with them.
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Conclusion
Mutual fund performance calculations will most likely include dividends if you’re buying into a stocks-based investment. The performance metric used will most likely be the total return of the investment over a specific number of years. The total return measures both capital gains and dividends paid.
However, you’ll also need to look at other metrics like the CAGR and the absolute return for a clear picture of the fund’s performance.
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