Mutual funds remain a popular method of investing for Canadians. The lay investor can achieve a degree of diversification and sophistication in his/her portfolio that wouldn’t be attainable through self-managing a direct portfolio. However, mutual funds also are much misunderstood by lay investors. This article looks at the “math” of mutual fund performance.

The funds all publish quarterly and annual reports. A typical report contains some
commentary from the fund manager as well as historical rate-of-return information and listing of top ten holdings. A few pie charts convey the allocation of investments across industries or geographic regions. The entire list of holdings is also presented, valued both at original cost and current market value. The nitty-gritty of the “math” appears in a set of three financial statements, which have been audited by a professional accounting firm.

We will aggregate two of these statements below for illustrative purposes, using real data from three historical reports:

 ($ million)  

Trimark Canadian
 

Elliott & Page Equity
 

Spectrum Canadian Equity
 Cash income  

13.544
 

1.356
 

4.816
 Income taxes  

-0.262
 

 0.000
 

-0.017
 Subtotal  

13.282
 

1.356
 

4.799
 Fund charges  

 -8.463
 

 -1.130
 

-4.323
 Subtotal  

4.819
 

.226
 

0.476
 Realized gains  

38.853
 

2.713
 

5.795
 Unrealized gains  

 17.829
 

  8.140
 

-5.610
 Total income  

61.501
 

11.079
 

0.661
 Opening value  

956.250
 

105.463
 

355.043
 New funds  

191.260
 

15.684
 

60.328
 Redemptions  

-69.542
 

– 7.179
 

-23.709
 Distributions  

 0.000
 

  – 0.230
 

-15.616
 Closing value  

1139.469
 

124.817
 

376.707

 

Cash income” represents the dividends and interest earned on the unit-holders’ behalf. “Realized gains” are profits made on selling assets. “Unrealized gains” represent paper gains from the purchase cost to present value. “Fund charges” are the fees charged by the fund company.

You can see that the fund managers collect a hefty fee, often equivalent to all or most of the cash income earned. Their ability to generate positive returns for you is dependent, then, on generating gains.

During the 1995 reporting period for Spectrum Canadian Equity, the market was
poor, resulting in, essentially, zero return. The other two funds reported three
months later, by which time the market had taken off, generating large gains and strong returns.

As the returns from cash income typically run from 2-4%, you are giving away a fair bit to the fund managers in exchange for their ability to generate gains. As your
portfolio grows, it may be wiser to eschew the fund companies and generate your own diversified portfolio of direct stock holdings, retaining the 2-4 % cash return for yourself.