If you're investing in mutual funds or ETFs, comparing their returns is important for making informed decisions. With so much information available, knowing what matters most when evaluating different funds can be challenging. This guide breaks down how to compare fund returns more effectively, helping you understand the key factors to make decisions more aligned with your financial goals.

Understanding Fund Returns

When people talk about fund returns, they’re generally referring to the gains or losses generated by a fund over a specific period. These returns are often shown as year-to-date (YTD), one-year, five-year, or ten-year returns. To compare fund returns more effectively, it’s important to look beyond the numbers and consider factors such as the fund’s risk level, fees, and broader market conditions.

Note: some funds don’t even exist anymore, stopping you from being able to compare their returns (e.g. sometimes poorly returning funds get shut down)

Step 1: Look at Historical Returns

Looking at one-year, five-year, and ten-year returns provides insight into a fund’s consistency and potential for long-term growth. However, historical returns are not a reliable predictor of future performance. They offer context for how the fund reacted to past market conditions but shouldn’t be viewed as a guarantee.

Hypothetical Example: Comparing Fund A with an average ten-year return of 8% to Fund B’s 10% may seem straightforward, but you should also account for factors such as risk, asset allocation, and management approach before deciding which is more suitable for your portfolio.

Step 2: Evaluate Risk-Adjusted Returns

Higher returns often come with higher risk, making it harder to compare funds. A common metric for evaluating risk is the Sharpe Ratio, which measures how much return a fund provides per unit of risk. A higher Sharpe Ratio suggests better returns relative to the risk assumed, which helps assess if the higher returns justify the potential increased volatility.

How to Calculate the Sharpe Ratio:

To calculate the Sharpe Ratio, follow these steps:

1. Determine the Fund’s Return: First, find the annual return of the fund.
2. Subtract the Risk-Free Rate: The risk-free rate typically used is the return on short-term U.S. Treasury bonds. Subtract this rate from the fund’s return to calculate the excess return.some text
   • Formula: Excess Return = Fund Return - Risk-Free Rate
3. Calculate Standard Deviation: Measure the fund’s volatility by calculating the standard deviation of its returns over time.
4. Divide the Excess Return by the Standard Deviation: This gives you the Sharpe Ratio, indicating how much return you’re receiving for each unit of risk taken.

Where:

Step-by-step breakdown of a hypothetical example portfolio:

1. Fund's return (Rp): 8%
2. Risk-free rate (Rf): 2%
3. Excess return (Rp - Rf): 8% - 2% = 6%
4. Standard deviation (σ): 10%
5. Sharpe Ratio: 6% / 10% = 0.6

This is useful because it shows that for every unit of risk taken, the fund delivers a 0.6% return. 

A higher Sharpe Ratio means you're getting more reward for each unit of risk you're exposed to.

• To calculate the Sharpe Ratio for your funds quickly, you can use this calculator.
• Risk-adjusted return: The Sharpe Ratio helps you understand whether the fund’s returns justify the level of risk you’re taking on. A higher Sharpe Ratio means that the fund is more efficient at delivering returns relative to its risk, making it a more attractive option for investors looking to balance growth and stability. A ratio below 1 usually indicates poor risk-adjusted performance, while a ratio above 1 suggests the fund is performing well compared to the risk.

Step 3: Consider the Impact of Fees

Fees can significantly erode your overall returns over time. It’s essential to understand the expense ratio—the percentage of a fund’s assets used to cover management costs. Even small fee differences can add up over time and reduce long-term returns. For mutual funds, pay special attention to front-loaded or back-loaded fees sometimes applied in addition to regular management fees.

Tools like PortfolioPilot.com let you visualize your fees across funds all in one place. They can even help you optimize your fees by suggesting lower-cost replacement funds with similar exposure.

Step 4: Analyze Consistency in Returns

Consistency is key when comparing fund returns. A high average return might be the result of volatile swings, which can expose you to more risk. Funds with steadier, more consistent returns may offer more reliability. Reviewing a fund’s annual returns helps you gauge how stable its performance has been over several years.

Step 5: Compare Against Benchmarks

Benchmarks provide a point of reference, helping to evaluate a fund's performance in the broader market. Comparing a fund’s returns to a relevant benchmark can show whether the fund manager is adding value.

How to Choose the Right Benchmark:

• Relevance to Fund Strategy: For example, large-cap U.S. equity funds are often compared against the S&P 500. International stock funds might be compared against the MSCI World Index.
• Sector-Specific Comparisons: If you’re looking at sector funds, compare them to a sector-specific index (e.g., technology-focused funds might be compared against a tech index).

Why Comparing to a Benchmark is Useful:

• Evaluate Manager Performance: Consistent outperformance of the benchmark can indicate strong management.
• Understand Market Exposure: Benchmarks also help you understand how a fund is positioned in the broader market.

Note: make sure that the benchmark you’re using has the same risk profile as the fund you’re evaluating, as the risk appetite of the fund can be used to increase overall returns. Also, confirm that fees are being factored into the benchmark comparison (it's much harder to outperform a benchmark after fees, which is typically what matters most).

Step 6: Align with Your Investment Goals and Time Horizon

Ensure that a fund’s performance aligns with your financial goals and time horizon. A fund suitable for someone planning to retire in 30 years may not work for someone with a shorter time horizon.

Hypothetical Example: A conservative investor with a five-year horizon may prioritize low volatility and consistent returns, while a younger investor might seek higher returns and be more comfortable with short-term risk.

Broader Market Context and How It Affects Fund Performance

Fund returns are not only influenced by internal factors like management and fees but also by macroeconomic conditions. Here are a few key factors that significantly impact fund performance:

Inflation:

High inflation erodes the purchasing power of money, often leading to increased interest rates. This can negatively impact bond funds, as bond prices typically fall when rates rise. Conversely, inflation can benefit certain commodity-based funds like gold or oil.

Interest Rates:

When interest rates rise, borrowing costs increase, which can slow economic growth and hurt equity funds. However, certain sectors like financials may benefit from higher rates. Bond funds, particularly those holding long-term bonds, often see declines when rates rise, as newer bonds offer higher yields, making existing ones less attractive.

Market Cycles:

During periods of economic expansion, growth-oriented funds like tech or consumer discretionary tend to perform better. In contrast, during downturns or recessions, defensive sectors like utilities and healthcare often show more resilience.

By considering the broader economic context, you can make more informed decisions about how your selected funds may perform under different market conditions.

Additional Considerations

We’re living in a time when Environmental, Social, and Governance (ESG) factors have significant attention. Investors aren’t just focused on financial returns anymore—they’re also looking at the broader impact of their investments. ESG criteria help investors evaluate whether companies are operating sustainably, treating employees fairly, and maintaining good governance practices. For many, aligning their portfolios with these values is becoming just as important as maximizing returns. As a result, ESG funds have seen a surge in popularity because they allow people to invest in companies that match their ethical beliefs while still aiming for long-term growth. Whether it’s focusing on environmental sustainability, social justice, or corporate transparency, ESG investing is reshaping how we think about building wealth.