Just as you should check the return on equity (ROE) of a stock, you should check the ROE of a mutual fund as a metric of fund management.
An ROE is a shorthand way of saying Return On Equity, the amount of money you get back when you invest cash. ROE is not just a simple number, but a way to determine how healthy a mutual fund is; this number helps you estimate the fund’s profitability, asset management, and financial leverage. A healthy ROE indicates that these three critical components of the mutual fund are also managed well by the fund’s caretakers. That’s because it is a very good indicator of how well management uses new and reinvested earnings to generate new cash.
ROE for a mutual fund can be calculated quickly and easily by taking a given year’s earnings (less extraordinary items) and dividing them by the average common shareholder’s equity. The year’s earnings are on the Consolidated Statement of Earnings for that year filed with the SEC, and is generally available in the Annual Report online. Make sure the Statement you look at is for a whole year, not a quarter. You can look at the quarters since the earnings should be fairly steady, though a whole year gives you a good sense of how the mutual fund manager used your money that year.
The shareholder’s equity is used because they are the only stakeholders in a company that do not have a fixed return. You can find the shareholder’s equity on the balance sheet, also generally available in the Annual Report. This is the difference between the total assets and the total liabilities. Shareholders equity refers to the assets generated by the business – the profits. The average shareholder’s equity is the shareholder’s equity divided by the number of shares held. This is often shown as a separate value called “book value.” If this number is relatively high, you’re probably looking at a healthy mutual fund.
But by dividing the single year’s earnings by the shareholder’s equity, you will get a percentage number, positive or negative, that is equal to the ROE.
With a mutual fund, though, you may want more than just one year’s ROE. You should check the ROE of several years, and compare them to see what kind of growth the fund has seen. Also look for a stable pattern of share purchases. A mutual fund that is selling a lot of shares in the year it has a great ROE may have a skewed ROE number, depending on how the accounting is done. You can use the ROE over several years to compare mutual funds, and you will begin to see how your mutual fund compares to others across the board. This gives you a much better idea of where to invest money in the future.
A similar strategy for using ROE as a metric of your mutual fund is to simply look at the average return on equity of the fund’s investments. The Microsoft Money Portal typically gives this information for mutual funds. The average return on equity will give you a general sense of the fund’s strategy as well as the quality of the companies that the fund manager selects. Look for a mutual fund that invests in companies with high return on equity but low price to earnings ratios.
ROE may also be called the “return on common equity” or the “return on average common equity.”