Understanding fund performance

It’s important to understand how your investments are performing, but performance reports aren't always easily understood. With terms like 'annualised returns', 'rolling returns' and 'annual returns' or 'indices', 'attribution' and 'contribution', performance reports can seem confusing. But having a better understanding of how results are reported could help you better appreciate how your investments are really performing, and whether you’re on track to meet your investment objectives. 

Annualised performance and compound annual growth rate

When quoted for a time period of more than one year, the returns shown in performance tables or charts are commonly annualised (see Figure 1). It is important to understand that an annualised three-year return of 10% does not mean that the fund has returned 10% over three years. Rather, it means that an investment has returned, on average, about 10% per year for three years. 

FIGURE 1: EXAMPLE OF AN ANNUALISED PERFORMANCE TABLE 

^{Annualised performance (AUD after fees) to 31 December 2019}  

^{Source: Colonial First State. Figures used for illustrative purposes only.}

In Figure 2 below, the amount of $1,331 is determined due to the effect of compounding interest on the initial investment over the three years. The 10% per year return is also known as the compound annual growth rate (CAGR). The annualised return, or CAGR, includes the effects of compounding interest and capital growth (that is, the increase in value of your investment over time), and may include the re‑investment of income such as dividends and returns of capital. If this is the case, it should be noted in the relevant performance table in your report. 

FIGURE 2: COMPOUND ANNUAL GROWTH RATE

^{Source: Colonial First State. Figures used for illustrative purposes only.} 

A three‑year annualised return of 10% doesn't necessarily mean a stock appreciated by 10% every year; rather, the stock has appreciated by 10% per year on average. As shown below, the fund may have two flat years followed by a strong year to average a 10% annualised return over three years.

FIGURE 3: PER ANNUM (PA) RETURN VS 3-YEAR ANNUALISED RETURN 

^{Source: Colonial First State. Figures used for illustrative purposes only.} 

This means an annualised return provides no indication as to the fund’s volatility over time. This can be likened to a car journey, where the average speed is 50 km/h. Sometimes the car may be stationary, other times exceeding 50 km/h, to average 50 km/h over the whole journey. Note that according to Australian regulatory guidelines, ’returns for periods of more than one year should be annualised' . That’s why annualised returns are the most common method of reporting in Australia, and should accompany alternative ways of presenting past performance for Australian‑based funds.

Rolling returns 

Rolling returns report regular performance, usually monthly or quarterly, over a set period of time – like one, three or five years. For example, a monthly, three‑year rolling return chart would show the three‑year annualised returns every month – that is, from January 2017 to December 2019 or February 2017 to January 2020 and so on. Put simply, using this example, it’s the three-year annualised return (or CAGR) plotted monthly. Reporting rolling returns has the effect of smoothing out any volatility to provide a clearer picture of fund performance over a longer time horizon, which can be useful for investors with longer‑term investment objectives. For example, compare the three-year rolling returns in Figure 4 with the same fund’s monthly returns in Figure 5.

Annual returns

Annual (or calendar year) returns show a fund’s performance over any given year. This can show how a fund performed during certain periods in time – for example, the 2020 Coronavirus crash.

FIGURE 6: EXAMPLE OF AN ANNUAL PERFORMANCE TABLE

^{Annual performance (AUD after fees) to 31 December 2019}

Source: Colonial First State. Figures used for illustrative purposes only. 

Unlike annualised returns, annual returns also provide a snapshot of a fund’s volatility. For example, over the 2019 calendar year, the fund returned 20.8% while over the following year, it returned ‑10.9% – a volatile range of 31.7% (see Figure 6 above). As illustrated in Figure 7, when considering annual return performance tables, it is important to remember that a percentage loss is not necessarily equal to a percentage gain. For example, a 50% loss requires a 100% gain to get back to where it started.

FIGURE 7: PERCENTAGE GAIN VS PERCENTAGE LOSS

Source: Colonial First State. Figures used for illustrative purposes only.

Net returns

Funds for everyday retail investors typically quote returns after the cost of fees has been subtracted, referred to as the net return. Over time, the cumulative effect of fees can make a difference to performance. The details of the different types of fees charged on managed funds are available in a fund’s Product Disclosure Statement, or PDS. Please note that for net return figures, all relevant distributions (see below) may be assumed to be reinvested in the fund in exchange for units.

Growth returns and distribution

A growth return represents the portion of the total fund return attributed to capital growth in the value of the fund’s investments. Distributions represent the amount of income generated by a fund’s investments over a given time period, which are generally paid to investors as a cash payment (sometimes quarterly or annually) or reinvested in the fund in exchange for units.

Indices

An index is a collection of companies (stocks) chosen to represent an investment sector – for example, by size, geography or industry. As seen in Figure 8 below, the S&P/ASX 50 Index comprises the 50 largest companies traded on the Australian Securities Exchange (share market) by market capitalisation (that is, the total number of shares multiplied by the current share price). 

There are hundreds of indices covering a wide range of sectors, countries and stock exchanges. Some of the commonly quoted indices include the S&P 500 (the top 500 companies in the United States), the S&P/ASX 200 (the top 200 companies in Australia), the FTSE 100 (the top 100 companies in the United Kingdom) and the MSCI World Index (which represents 1,601 leading companies worldwide). There are also more specialised indices that track specific sectors, such as the HSBC Global Mining Index or the UBS Global Infrastructure & Utilities Index. 

^{As at 1 June 2020}

Note: Any stocks mentioned are for illustrative purposes only and are not recommendations to you to buy, sell or hold.

Benchmark index

A benchmark index is chosen by a fund as a standard against which to measure its performance. A benchmark will typically be made up of similar stocks that the fund can invest in. For example, an Australian share fund’s index may be measured against the S&P/ASX 200 Accumulation Index. There are different kinds of indexes, however. For instance, an accumulation index takes dividends into account and will measure price growth as well as income from dividends. Conversely, a price index does not take dividends into account and will generally measure share price growth only.

Outperformance and underperformance

If a fund returns more than the benchmark, it is said to outperform relative to the benchmark. Similarly, if it returns less than the benchmark, it is said to underperform relative to the benchmark. Fees are sometimes charged when a fund outperforms its benchmark by a certain level, which is known as a performance fee. A fund can still outperform relative to the benchmark even if the absolute return (the fund’s performance regardless of the benchmark) is negative. For example, if the fund returns ‑10.0% and the benchmark returns ‑12.0%, the fund would still have outperformed by two percentage points, or 200 basis points (bps). Investment managers can be restricted as to what stocks they can invest in. This can mean that in the event of a market downturn, a manager may hold stocks they think won't fall as much in value to try to outperform the benchmark.

Relative overweight and underweight portfolio holdings

As previously mentioned, a benchmark consists of a basket of stocks. The stocks that comprise a benchmark are at different weights, relative to their market capitalisation. For example, BHP comprises about 6.7% of the ASX 200 (as at August 2020). If a fund holds more of a stock than the benchmark does, it is 'overweight' that stock. Conversely, if a fund holds less than the benchmark does, it is 'underweight' that stock. Investment managers seek to outperform the benchmark by being overweight and underweight in certain stocks; they are overweight in the stocks they expect to perform well and are underweight in the stocks they expect could perform poorly.

^{As at 1 June 2020}

Note: Any stocks mentioned are for illustrative purposes only and are not recommendations for you to buy, sell or hold.

Attribution and contribution

The effect on performance of a fund’s overweight or underweight positions is called attribution. This represents the investment manager’s stock-picking skills, as they will adjust their relative holdings in the fund to the stocks they think are likely to underperform or outperform. Below, Figure 11 illustrates the effect that a relative holding to the benchmark has on performance attribution.

^{Source: Colonial First State}

A stock’s effect on the performance of the fund, regardless of whether it is overweight or underweight, is called contribution. This is more representative of individual share price movements rather than any stock-picking skill by investment managers. For example, if a fund holds BHP and BHP’s share price rises, this will have a positive effect on the fund’s absolute return.

Volatility

A fund’s volatility measures how much the fund’s returns fluctuate over time, usually measured against a benchmark index. Typically, the more volatile or higher-risk a fund is, the more likely it is to experience price fluctuations over short periods of time. For this reason, volatile funds may be more suitable for long‑term investing to help reduce the risk of short‑term losses of capital. Because of the fluctuations that occur in more volatile funds, it is important to consider longer‑term performance (generally over more than three years) when looking at investment performance, and not focus too heavily on the past month or quarter.

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