Morningstar.com
There's More Than One Way to Read a Return
Tuesday July 17, 7:00 am ET
By Andrew Gogerty

With the calendar quarter just ending, mutual fund companies are by now printing and mailing account statements to investors, and many of them contain tables of fund and account total returns. It also means that for the next month or so many Morningstar fund analysts, including myself, will be peppered with questions and comments from friends and family such as "Why did my fund lose money last quarter?!" or "I'm happy--my fund went up 3%." Others will turn to Morningstar.com to see how their funds' returns compared with their category peers (also called "relative returns.")

Both absolute and relative returns are important, but it would be unwise to run blindly into the arms of either measure. Both have their good and bad sides, but investors who view both through a critical lens will have the best chances of success. To make the most of both, take the following factors into consideration.

Absolute Returns
People want their money to grow; that's why they invest it. As a result, absolute returns--the extent to which you've made or lost money in an investment--are often the first data points at which investors look. After all, you probably don't care if you own the worst investment in a category if that fund has helped you reach your goals. Conversely, it's cold comfort to know that you chose the best fund in a group if you lost money over the life of your investment.

In fact, most investors hate to lose money, no matter the amount. Morningstar has built this concept into its Morningstar Rating for mutual funds and measures risk as the amount of variation in the fund's performance, with more emphasis on downward variation. This construct follows the concept of "marginal utility," which says that losses pain people more than gains provide happiness. Losses are in fact painful and take longer to recover from than many people think. Consider this: A mutual fund (or any investment for that matter) that loses 20% in a year would have to gain 25% going forward to bring the investor back to break-even.

How to Use Absolute Returns
It's a mistake to focus disproportionately on how much your investments have returned--in absolute or relative terms--over short time periods such as a year or less. But looking at your investments' longer-term returns is a great way to check up on whether you're on track to meet your goals. Look at your investments' five- and 10-year returns both individually and as a group to see whether they're meeting your expectations. For example, if you bought a stock fund to help grow your capital but its gains have barely kept up with inflation, that's a good reason to question whether that fund is doing the job you bought it to do. It may also mean that you'll need to invest more money along the way and not rely solely on compounding returns to get you to the finish line.

Relative Returns
Competition is part and parcel of the investment business. Relative returns show you how well an investment has performed alongside its competition, whether that's defined as a market benchmark or other funds that use a similar strategy. On its fund pages, Morningstar provides fund returns relative to two indexes, a standard market benchmark such as the S&P 500 Index as well as a "best-fit index," an index that corresponds closely to a given fund's portfolio. Morningstar's fund pages also show you how a fund has fared relative to other funds in that same category. For example, the Total Returns tab on Morningstar.com for Evergreen Growth (NASDAQ:EGWAX - News) shows that the fund's returns have beaten the S&P 500 Index--the standard benchmark for all stock funds. Its returns have also topped the Morningstar Small Growth Index, which holds many of the same securities as the fund. Relative to other funds in the small-growth category, however, the fund's five-year and 10-year return rankings are lackluster, meaning that while it has done well versus certain indexes, it has not been a standout among its peers. (The relative return rankings fall between 1 and 100, and a low number is better than a high one.)

How to Use Relative Returns
Relative returns can help you gauge how well an investment is doing alongside investments of a similar ilk. For example, if you've decided that you would like to add an international fund to your portfolio, you'll want to check up on that fund's historical risk/reward profile relative to other funds that invest overseas, not relative to funds that invest domestically. Eyeballing a fund's relative returns over longer time periods can also be a good way to keep tabs on whether your investments are earning their keep. If a fund has dramatically underperformed its peers over the past five years, that can be a good reason to investigate what's going on. It may turn out it's well worth buying more shares on weakness--as is currently our take on Clipper Fund (NASDAQ:CFIMX - News)--or it may be that the fund has fundamental problems that argue for cutting it loose, as is the case with Putnam Voyager (NASDAQ:PVOYX - News) and Fidelity Blue Chip Growth (NASDAQ:FBGRX - News).

Why Both Return Measures Are Important
In general, we think relative returns are best viewed in concert with absolute returns. A fund's relative returns can often fluctuate wildly from one year to the next, but it's the absolute returns that truly create or destroy wealth in a portfolio. The relative return rankings of Jensen Fund (NASDAQ:JENSX - News), for example, have bounced around like a pogo stick, but the fund has had very low volatility of its absolute returns. By contrast, I'm sure it was little comfort for investors in T. Rowe Price Media & Telecommunications (NASDAQ:PRMTX - News) to know that the fund's relative returns were the best among its communications peer group during the 2000-02 bear market when the fund lost a cumulative 50%.

Andrew Gogerty does not own shares in any of the securities mentioned above.