Skip to main content
Publish date:

Building a Better Metric at Morningstar

'Investor Returns' is constructed to give investors an improved perspective on fund performance.

If you're trying to decide which mutual funds or exchange-traded funds to invest in, you may want to look beyond total returns.

Total return is the standard metric that well-known investment research firm


(MORN) - Get Morningstar, Inc. Report

and pretty much everyone else has historically used to analyze performance. But that's about to change.

Starting in November, investors who go to Morningstar's

Web site can size up mutual funds and ETFs by seeing not only their total returns, but also "investor returns" -- a data point that has not been widely available.

Here's the difference: Total returns measure what you would have earned had you bought and held the fund, reinvesting all dividends, beginning on the first day of the performance period.

For instance, if you were looking at a fund's three-year performance, the total return would show you what you would have amassed had you invested a lump sum on the first day that the three-year period began.

The problem with that seems fairly obvious.

"It's not the whole picture," says Russel Kinnel, Morningstar's director of mutual fund research. "Most investors didn't invest precisely three, five or 10 years ago."

As a result, he says, investors' returns generally aren't as good as the official total return because individuals come in after a period of strong performance and sell after a period of weak performance.

This is where investor returns come in. When used as a complement to total returns, Morningstar believes that the metric will give investors a better idea of what's going on with a fund. Specifically, Kinnel says "it gets you thinking about the importance of timing and performance-chasing."

TheStreet Recommends

Investor returns estimate the return earned collectively by all the investors in a fund -- it accounts for all cash flows from purchases and sales and the growth in fund assets. (Morningstar plans to provide one-, three-, five-, and 10-year trailing and annual investor returns.)

According to Kinnel, "If you instead look at the investor return, whichtakes regular returns and weighs them based on cash flows -- when peoplebought and sold -- that gives you a sense of what people actually made inthe fund, which in turn tells you something about how easy the fund isto use."

An example that Kinnel provides of a more stable fund that would have similar total and investor returns is the

(PRFDX) - Get T. Rowe Price Equity Income Fd Report

T. Rowe Price Equity Income fund. In this product, he says, the returns are never so extreme that they inspire fear or greed.

"It's kind of steady, and so people react to it in a steady fashion ... So the total return and investor return would be more similar."

On the other hand, if you were to look at a really aggressive growth fund -- in which almost no one buys when the fund loses 50% but into which money often piles when it rises 50% -- there would be a big gap between the total and investor returns.

So how should you interpret the two numbers?

If you examine a fund and find that the investor and total returns are closely aligned, you can infer that it is probably a steady fund that people have used well, Kinnel says.

On the other hand, if there is a big gap in those numbers, it is perhaps an indication that the fund is one that emotion-driven investors have used poorly.

If that is the case, he recommends taking a closer look at returns for previous periods. Also, he says, you may want to consider dollar-cost averaging into the fund or making investments in it of a smaller size than you had planned.

But there is one thing to keep in mind when looking at these numbers: There could be a large gap in the figures for investor and total returns in a category where returns are simply not in line with the markets.

Take small-cap value, for instance. These funds tend to be pretty tame, but if you look out five to seven years, Kinnel says, you'll see a gap in those figures. That is not because there is a lot of panic selling in that group, he says, but simply because, as an asset class, small-caps often perform differently than the overall market.