A graph a lot like this one appeared in one of our national newspapers recently in an ad for a mutual fund. At first glance, it looks like this fund has consistently outperformed the index that it’s measured against. It has increased by a whopping 194% since early 2000 compared to what it’s measured against, which increased by a paltry 51%.
I’m not really sure what that means. Both went up in value over the period so capital was preserved. Obviously, they want you to focus on the fact that they earned 194% over the roughly 16 years and the MSCI World Index only returned 51% over the same period. It sure looks like the fund did better over the whole period. It’s going up a lot faster since the 2008 financial crisis and down less before. This chart is an example of one of my pet peeves. The ad said “The quality advantage: Capital preservation contributed to long-term performance.”
The type of chart they’ve used is called a linear chart. They do not give a clear picture of long-term investment growth. A log chart, on the other hand, shows what investors really want to know. I know logs (logarithms) scare most people because of the trauma they endured in trying to learn about them in high school. All you need to know is that:
- With a linear chart (see Chart 1 above), an equal increase along the vertical axis (left side of the chart) represents an equal increase in the dollar amount. This means that the increase from 50 to 100 looks the same as the increase from 250 to 300. They are the same amount, but not the same percentage.
- In a log chart (see Chart 2 below), an equal increase along the vertical axis represents an equal percentage increase. What this means is that the increase from 50 to 100 is the same as the increase from 150 to 300 – they both doubled. This is what most investors are really interested in. An investor who earns $5,000 on his $10,000 investment will be a lot happier than the investor who earns $5,000 on his $100,000 investment over the same period of time. I’ve recreated the chart, but this time using a log scale on the vertical axis so we can get a more accurate picture of how well this fund did in relative terms.
This is also an excellent example of how past performance doesn’t predict future performance. Someone looking at the performance of the advertised fund after the first two years covered in the chart would have thought, “Holy cow, the fund earned 50% over the last few years and the index lost 50%. I gotta get me some of that fund.” They would have been disappointed over the next 14 years since they would be paying fees for a fund that was supposed to perform better than the index, when in reality, this wasn’t the case at all. With the exception of the first couple of years, you can see that the blue and red lines follow each other very closely. This means, since part way through 2002, the fund and the index it’s measured against have earned the same percentage return. In fairness, the fund out performed big time for the first couple years, despite the tech bubble bursting at that time. So, maybe that’s the preservation of capital they were talking about in the ad when describing the fund. You can see that in Chart 1 above too, if you analyze it carefully, but it’s not obvious. You have to look closely – really closely. For example, after the tech bubble burst in 2002, the fund being advertised and the benchmark it’s compared to have both almost exactly tripled. If you look at the financial crisis in 2008, they both lost about 50% of their value, so capital wasn’t preserved very well that time by either the fund or the index.
Things aren’t always as they appear. It’s important to look beyond the pretty picture to understand what it’s really telling you – or just as important, what it’s not telling you.