Mutual funds are sold primarily on the basis of ‘performance’ measured by historical ‘total return’.

The famous Morningstar rating system is based on ‘total return’, in this case ‘risk-adjusted total return’ relative to funds of the same asset category.

The average American mutual fund investor is accumulating resources for retirement, say 20 or 30 years hence. The typical owner of mutual funds is unsophisticated and does not delve deeply into the significance of Morningstar ratings or total return figures.

The SEC allows promoters of mutual funds to trumpet historical ‘total returns’ as long as there is a disclaimer that “past performance is not necessarily indicative of future performance”.

A question worth considering is this: “Are investors being mislead by statistics on total return?”

The Conundrum of Total Return

Let us say that you are an investor with $100,000 to invest for 20 years to build up retirement income. Here are the figures you are given on which to make a decision between two funds with the same Morningstar rating:

Fund One has a total return of 7% and is covered by insurance that guarantees this same total return for twenty years.

Fund Two has a total return of 8% and is covered by insurance that guarantees this same total return for twenty years.

Which of these two funds should you choose as your retirement vehicle?

Here is a hint: Fund One will have a value of $386,970 at the end of twenty years; Fund Two will have a value of $466,100 at the end of the same period.

Now, whatever choice you yourself might make, you’ll probably agree that the average mutual fund investor will choose Fund Two for the simple reason that $466,100 is more that $386,970.

The Weak Point of Total Return

Total return is the sum of cash returns paid by the issuer and unrealized capital gains in the market price of the security. Both are given equal weight and merit when measuring ‘performance’.

Now, if I told you that the total return on Fund One, above, consisted entirely of income paid by the issuer, while the total return on Fund Two consisted entirely of unrealized capital gains, would your choice be any different?

Most investors in mutual funds, even if they had information as to the breakdown of total return, would still choose Fund Two.

Their reasoning would simply be that at at the end of twenty years, when they retire, they would expect to sell Fund Two and invest in Fund One (or something equivalent) and obtain a higher retirement income than if they had invested in Fund One from the beginning.

In other words, by assuming that capital gains and dividends are the same, investors disregard future market liquidity risk. This is the fatal weakness in using total return as a principal selector for long-term investments.

Baby Boomers and Real World Liquidity

In our example, an investor in Fund One would be receiving annual dividends of $25,320 at the end of twenty years, and assuming that Fund One continues to have the same dividend paying capacity, the investor could look for receiving this income for life and still having $386,970 to pass on to heirs.

The investor in Fund Two, however, would receive no income from the issuer and his or her retirement income would depend entirely on someone else (not the issuer) being willing to buy Fund Two for $466,100.

If at the end of twenty years there are many more sellers of Fund Two than buyers, as might be the case when Baby Boomers retire, an investor in Fund Two may end up with less income that the investor in Fund One.

Morningstar’s ‘Risk Adjustment’ Is Largely Irrelevant

For long-term investors who are the principal holders of mutual funds, a fund’s volatility over the last three years is not relevant to the risk of market illiquidity twenty years hence.

Even William F. Sharpe, the Nobel laureate, before digressing into lengthy mathematics under the “heroic assumption that statistics from historic frequency distributions are reliable predictors of corresponding statistics from a probability distribution of future returns”, admits that:

” … there is ample evidence that measures of average or cumulative return are at best highly imperfect predictors of expected future return. … “

“Morningstar’s Risk-adjusted Ratings”, William F. Sharpe, Stanford University, January, 1998

From the point of view of Capital Flow Analysis and based on reasonable expectations of market conditions when Baby Boomers try to unload low-cash-yield investments in order to switch into high-cash-yield investments over the coming decades, it would appear that Morningstar’s ‘risk adjusted total return’ is not a useful measure of the longer-term investment well-being of most holders of mutual funds.

The SEC Drops the Ball

By insisting only on the lame disclaimer that ‘past performance is no indicator of future performance’, the SEC does a poor job of protecting unsophisticated mutual fund investors who make up most of this market segment.

‘Total Return’ is the favorite child of mutual fund promoters who also encourage aggressive corporate stock buybacks to jack up market prices in the short-run, even when putting the longer-term earnings capacity of companies in jeopardy.

The use of ‘total return’ as a prime marketing tool in mutual fund distribution, together with use of stock buybacks to manipulate the unrealized capital gains component of this statistic, are important in understanding the behavior of the U.S. equity market over the last generation.

The slow unwinding of these practices as Baby Boomers retire may be characteristic of the next phase of the stock market.

This entry was posted on Sunday, May 28th, 2006 at 1:35 pm and is filed under Fund Shares, Fund Managers, Investment Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.

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