Let’s say you’re considering investing in a mutual fund. You may be wondering, “How much can I expect to earn on this investment?”
It’s a fair question. It’s natural to want to know how much you will get out of an investment before you put any money into it. But unfortunately, there isn’t one answer that applies to all or even most mutual funds. Many factors determine what kind of return you can expect from any given fund, including:
- Fund management style
- Fund goals
- Fund history and performance records
- Market conditions and trends
Choosing mutual funds for your portfolio is very personal, so it’s important to find funds that are right for you.
Mutual fund companies publish a great deal of information in their fund’s prospectus, including past performance records, expense ratios, asset allocations, and investment strategy.
So no matter what kind of mutual fund investing you’re looking to do and your investment objectives, there are probably several funds that could meet your needs.
That’s not to say that every mutual fund is a guarantee of future results. Some mutual funds do poorly or have fees that cut into potential gains. But with so many quality mutual funds on the market, it’s possible to find some that offer solid returns for your investment decisions over time.
What is a good mutual fund return?
A good mutual fund return satisfies the investor’s individual needs and risk tolerance. But, of course, this is a subjective definition and varies from investor to investor.
A good mutual fund return can be grouped into different benchmarks based on the following categories:
- How consistent the growth strategies are with less risk and volatility than the market as a whole.
- The level of returns on investments to reach the investor’s financial goals or cover living expenses in retirement.
- The goal might be steady growth to preserve principal rather than rapid growth through higher-risk investments. For example, if the investor is investing to benefit future generations, such as grandchildren or great-grandchildren.
There are no universal standards for defining a good mutual fund return, nor is there any universal standard for what constitutes a good rate of return for an individual investor.
Generally speaking, a good rate of return falls somewhere between 6 percent and 10 percent annually over time when adjusted for inflation, but it may also vary from year to year.
Other factors to keep in mind:
- Mutual funds are designed to be diversified and generally contain several stocks, bonds, or other investments. Returns can vary across each one.
- The fund manager selects individual mutual fund investments designed to help the investor meet their investment goals and risk tolerance.
- Many mutual funds aim to meet the needs of this type of investor by investing in stocks and bonds in companies that have proven records of consistent growth with little volatility. This type of fund may not compete with the market average during bull markets, but it will tend to outperform the market average during bear markets when most stock prices are declining.
To get a true picture of a mutual fund’s returns over a specified time, investors have to understand what annual and annualized returns are beyond just looking at total returns.
What is an annual return?
Annual return is the percentage change in investment over one year. The return on mutual funds can vary widely, depending on various factors.
The annual return on a mutual fund can be expressed in two different ways: absolute and relative.
- Absolute return represents the actual percent change in the fund’s value, whereas relative return measures the fund’s performance with some benchmark or index.
- Relative return makes it possible to compare how a particular fund has done against other investments, such as stocks, bonds, or money market instruments.
Investors can use financial websites or other online calculators to easily find these returns and determine which mutual value funds to consider.
Annual returns should be compared with other investments of similar risk levels to determine whether it was a good investment.
How to calculate mutual fund annual return
Annual return is calculated using this formula:
Annual Return = (Ending Value of Investment – Beginning Value of Investment) / Beginning Value
Annual returns can be positive or negative, depending on whether the ending value of an investment is higher or lower than the beginning value.
For example, if you invest $10,000 in a stock and at the end of one year it’s worth $12,000, your annual return would be 20%, or ($12,000 – $10,000) / $10,000.
However, if your investment were worth only $9,000 at the end of one year, your annual return would be negative 10%, or ($9,000 – $10,000) / $10,000.
What is annualized return?
On the other hand, annualized returns refer to the percentage change of a mutual fund investment over periods that can be shorter or longer than the span of one year.
However, it’s ‘annualized,’ meaning it’s converted into a yearly rate of return.
How to calculate mutual fund annualized return
- First, determine total returns, the same step as annual returns. In mutual fund cases, net asset value is considered.
**Total returns = (Ending NAV – Initial NAV )/Initial NAV **
In this case, the “ending” and “initial” periods are not defined by a year. It can be anywhere between a month to several years.
- The formula is tweaked:
Annualized return = (1 + TR)^1/N – 1
where TR = the total return and N = the number of years
Example
Let’s say a growth fund had an initial price of $10,000 and ending price of $12,500 over a six-year period.
Total return = 12,500 – 10,000 / 10,000 = 0.25
So the annualized return would be:
(1+0.25)^1/6 – 1 = 3.79
To make it simple for you, check out this calculator.
The difference between return on investment and return of investment
A common misconception regarding return on investment is that it’s the same thing as the return of investment. These terms may sound similar, but they have different meanings and calculate different things.
- The return realized by the investor is known as the return on investment (ROI). It is the actual return that the investor receives at the end of the day after accounting for their costs.
- The return of the investment is the return from the investment itself. Return of investment is the actual return earned by the money used in the initial investment.
When considering investment products with high fees and costs—such as hedge funds—the actual returns experienced by investors may be far lower than the reported returns of those products.
Example
For example, if an investor buys a money market fund at a value of $1,000 and sells it for $1,020 when it matures, the investor has earned a 2% annual return. This is the return on investment based on what happened to the fund.
However, if an investor buys that same MMF instrument for $4,000 in a secondary market and sells it for $4,200 when it matures, he has earned a 5% annual return of investment. He received $200 in cash back from his $4,000 original investment.
**How to choose a mutual fund based on returns **
When choosing a mutual fund, don’t get thrown off by all the varieties of funds available, ranging from large-cap, mid-cap, and small-cap funds, equity funds to index funds and bond funds.
No matter the kind of fund you choose to invest in, your fund shares purchases will be effective only if they align with your investment plan.
Whether you’re investing for the short-term or long-term, make sure to look at the following factors.
Look at long-term returns
The performance of a mutual fund is an important indicator of its viability, so investors must review a fund’s past performance before investing.
Look at the last year
A mutual fund’s performance over the last year is one indication of how it may perform in the future. When examining a fund’s annual return, look at the percentage change in its NAV. If the fund has a low annual percentage return over the previous year, consider why it might have performed poorly.
Suppose you are evaluating the performance of a small-cap value fund, for example, and you see that it performed poorly over the last year even though small-cap value funds were performing well as a group. In that case, there might be something wrong with this particular fund.
Look at the performance since inception
You can also look at how a fund has performed since its inception. See the distributions of asset classes and do a deep dive into how each was balanced and the average returns of each.
Go long-term
When considering long-term performance, make sure you go beyond just three years or even ten years. Consider the past 15-year period.
If you look at short periods, you might find that a fund has had an average annual return that is negative! Over long periods, however, most mutual funds have had positive returns.
Compare performance to peers
You should also look at how well or poorly the fund’s returns compare to other funds that are similar to it in investment strategy and goals. A fund’s relative performance can reveal whether it has been a good or bad performer over a given time.
For example, if a growth stock fund has an average annual return of 10% over 5 years, but its peers are averaging 11%, the fund is considered underperforming.
Choose a benchmark
There are many different types of mutual funds to choose from, and each has its own set of characteristics. When evaluating a particular fund, you want to make comparisons with a suitable benchmark.
You can’t compare an actively managed fund with an index fund that tracks the same market segment.
For instance, the Vanguard 500 Index Fund replicates the holdings and performance of the S&P 500, while Fidelity Magellan Fund has a portfolio manager who tries to pick stocks that will outperform the S&P 500.
The best way to measure this type of active fund is by comparing it with other actively managed funds in the same category with similar investment objectives.
This leads to the next factor.
Consider mutual fund categories
When you start looking at different mutual funds, it can be overwhelming. One way to make sense of the jumble is to organize the funds by their primary investments.
Keep these factors in mind:
- The category in which a fund invests makes a big difference in its performance and how risky it is.
- Over time, large-cap stock funds have delivered better returns than small-cap stock funds but more volatility. Bonds have less risk and lower returns than stocks.
- Every fund carries expenses that affect your return over time. Also important: whether the fees are front-end (paid upfront) or back-end (paid when you sell).
- As with any investment decision you make, start with your goals and then choose the type of fund that will work best toward meeting them.
Check out the Morningstar Category System
The Morningstar category system is a good place to start when choosing benchmarks for your funds.
Morningstar classifies nearly all mutual funds by style box and investment objective. It groups stocks into ten broad categories based on market capitalization (large-, mid-, and small-cap) and then divides each of those categories into value and growth categories.
It also showcases these returns over a three, five, ten, and fifteen-year period.
Compare mutual funds with other investment returns
Mutual funds are a good investment because they provide you with the opportunity to diversify your portfolio. Diversifying your portfolio means you’re not putting all your eggs in one basket, so if something happens to one investment, it may not hurt you as much as if all of your money was tied up in that one investment.
But you should be sure this is how you want to invest your money.
Before deciding to invest in mutual funds, you should also check out the returns of alternate investments such as:
- Individual stocks
- Bonds
- Exchange-traded funds
- Certificates of deposit (CDs)
Each type of investment has its strengths and weaknesses.
For example, an individual stock can have very high returns, which also carries significant risk. A CD is safer, but it doesn’t typically earn as much interest as other types of investments. By investing in a mutual fund instead of individual stocks or CDs, you can reduce your risk and still earn more than you would with a CD.
It all depends on your investment plans and the kind of returns you’re looking for as an individual investor.
FAQs
How do I invest in mutual funds?
To start investing in mutual funds, you need a special type of account. This is usually a brokerage account or retirement account. Once you’ve opened these accounts, you can place an order to buy units from the mutual funds you want to invest in.
Are mutual funds a good investment?
Mutual funds are a great investment management strategy for investors looking to diversify. For example, suppose you are hesitant to invest directly in the stock market and want to have a diverse pool of investments from small camp funds, emerging markets, and even fixed income instruments. In that case, mutual funds are a great idea.
How do mutual funds make money?
Mutual funds make profits by charging management fees as the cost to run them. This is shown through the expense ratio, which shows you how much of $1 is given to fund managers.