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When you invest in a mutual fund, your fund manager has a lot more insight into how your money is performing compared to how much you do, which is unfair. In order to gauge how much money you’re making through your investments, you have to measure and track your performance.
In this article, we’re going to explore how mutual funds make money, how they return value to you, and how you can accurately track that value to make informed investment decisions.
How do mutual funds make money?
When you invest in a mutual fund, you don’t directly make money from the fund itself. Instead, you have the potential to benefit from the growth of the fund’s underlying investments (such as stocks, bonds, or real estate). This growth can occur in two ways:
- Capital appreciation – If the value of the fund’s holdings increases over time, the price per share of the mutual fund also rises. When you sell your shares later, you can profit from the difference between the purchase price and the higher selling price. This is called capital appreciation and is similar to when you invest directly in stocks.
- Distributions – The fund may also distribute income generated from its investments in the form of dividends (from stocks) or interest (from bonds). These distributions can be reinvested back into the fund to compound your returns, or you can choose to receive them as cash.
Your potential return on investment comes from the combined effect of capital appreciation and reinvested or received distributions.
Tracking gains of a mutual fund investment
When looking for a mutual fund to invest in, professional investors calculate the mutual fund’s performance – its growth over the years. Mutual fund companies, correspondingly, exhibit metrics like the growth of their asset under management (AUM) and fund flow as their business strength to attract investors.
However, historical performance that’s published on the fund’s investor website is hardly always accurate. To accurately gauge whether the fund you’re considering made real returns, you have to dive a little bit deeper.
Consider the following metrics also:
Tracking category performance
This compares the fund’s return to a benchmark or category average. For example, if a large-cap fund returns 10% in a year and the average large-cap fund returns 8%, the category performance component would be +2%.
This reveals how the fund stacks up against its peers within the same investment style or asset class. A positive value indicates the fund is outperforming its category, while a negative value suggests it’s underperforming.
Excess performance component
This isolates the fund manager’s skill by taking the difference between the fund’s return and its category performance.
This component reveals the alpha, or excess return generated by the fund manager compared to the benchmark. A positive value suggests the manager is actively adding value, while a negative value indicates they may not be outperforming the market passively.
Category flows component
This assesses the impact of investor sentiment on the fund’s performance. It analyses how inflows (investments) and outflows (redemptions) from the entire category affect its overall return.
The category flows component highlights the influence of broader market trends and investor confidence on the category’s performance. A positive value might indicate investors are optimistic about the entire category, while a negative value could suggest their concerns are impacting the overall return.
Excess flows component
The excess flows component isolates the effect of fund-specific investor sentiment. It takes the difference between the fund’s return and its category’s return, adjusted for category flows.
This reveals if investor preference towards the specific fund contributed to its performance, independent of the broader category trends. A positive value suggests investors have confidence in the specific fund, potentially influencing its return beyond the category performance.
Overall performance
By examining all four components, you gain a multi-dimensional perspective on the mutual fund’s performance. You can assess the fund manager’s effectiveness, understand the impact of market conditions, and evaluate the influence of investor psychology on the fund’s return trajectory. This comprehensive analysis allows you to make informed investment decisions based on a deeper understanding of the factors driving the fund’s performance.
Frequently Asked Questions
Category performance compares the fund to its peers, while excess performance isolates the fund manager’s contribution by removing the category’s influence.
The excess flows component helps identify if your fund’s return is driven by investor preference for the fund itself or simply following the category trend.
No. Analysing all four components provides a holistic view of the factors driving the fund’s performance, offering a more informed decision-making process.
Not necessarily. A high positive value might also suggest the fund manager is taking on excessive risk to achieve those returns.
Yes, the category flows component reveals how investor sentiment towards the entire category can affect your specific fund’s return.