Question: 
I am studying investments and I'm using the Fidelity Magellan fund as a case study. How well has this fund performed in recent years, and what benchmark do you use to evaluate it? What does "good performance" mean to you? Does it include anything other than just return? Would you have recommended Magellan in 1995, or any other growth fund?
Click here to read Merriman's answer!

Answer:
Those are very good questions, and I'll try to give you good answers. If you are a student of investments, one excellent online resource you should know about is Morningstar, which you'll find at www.morningstar.com. If you go to that site and type in the ticker symbol for Magellan, FMAGX, you'll find a lot of information on the fund.

Under historical returns, when I checked in the first week of December 2001, I found that Magellan had a return of minus 13.3 percent for the past year. I found its compound rates of return for three years (2.9 percent), five years (11.2 percent) and l0 years (14.1 percent).

Those numbers are only meaningful if you compare them to something. So what is that thing? It's not as simple a question as you think, but I'll give you two possible answers.

First you could compare Magellan's performance, as Morningstar does (and undoubtedly as Fidelity does) to the Standard & Poor's 500 Index. In this case, Morningstar indicates that Magellan beat the index by 1.9 percentage points over the past three years. Over the past year, Magellan was 0.8 percent behind the S&P 500 Index; the fund beat the index by 0.1 percent over five years and trailed it by a truly insignificant amount, 0.01 percent (that's a difference of $10 on a $100,000 investment) over 10 years.

I think you could regard Magellan as a rough proxy for the Standard & Poor's 500 Index, but with higher expenses.

Magellan's expenses are 0.88 percent of its assets. Vanguard's 500 Index Fund has expenses of 0.18 percent. That difference is likely to persist, and over a long period of time that difference will have a surprisingly high impact on the two funds' comparative performance.
If we're talking about a taxable account, tax efficiency becomes a major issue. Vanguard's 500 Index fund has a tax-adjusted return of 13.0 percent over the past 10 years. Magellan's tax-adjusted return in the same period was 11.3 percent. That means an investor got to keep much more of the return from the index fund than from Magellan. This factor doesn't matter, however, if you're considering funds for an IRA or a 401(k) plan.

The second way to compare this return, and the one that is more important for any one investor, is to hold it up against whatever rate of return you need in order to reach your investment goals. For instance, I know somebody who has determined he can meet his long-range retirement goals if his investments return 11 percent a year. To that person, Magellan succeeded over the past 10 years and five years. But Magellan failed over the past three-year and one-year periods (as did most growth funds).

"Good performance" is also a subjective thing. I think it includes acceptable benchmark performance (as we just discussed) and also risk. An investment that takes you past your risk tolerance is likely to make you want to sell in a panic, or at least loose your peace of mind. That is not good performance in my book.

To measure performance against risk, the question is: How much risk did this investment subject you to, and did it give you an adequate reward for taking that risk. The general principal is that investors are rewarded for taking risks. If you take more risk, you should get more reward. If you take less risk, you should expect less reward.

There's a nifty formula used to determine if some investment in a given period of time gave investors more or less of the premium reward that they "deserved" after considering the amount of risk they took.

The answer is summed up in a single statistic known as "alpha." A positive alpha indicates you were more than adequately rewarded for the risk you took. A negative alpha means you were inadequately compensated for the risk you took.

If you look again at Morningstar's report on Fidelity Magellan, you'll see there's a link you can click to "MPT Stats." Click on that and you'll find the fund's alpha against the Standard & Poor's 500 Index for the trailing three years. In this case, the alpha is a positive 2.4, indicating that over the past three years, Magellan delivered a return that was more than adequate for the risk that it subjected investors to.
So, by some measures Magellan was a good performer and by some measures Magellan was a poor performer. It depends on what is important to each investor.

We would not have recommended Magellan in 1995, because it's a load fund and because it's an actively managed fund. We prefer no-load funds and index funds because, other things being equal, they leave more money for investors at the end of the day.

We would and did recommend growth funds in 1995. But we didn't recommend that investors put all their money into such funds. We recommended then and now that investors carefully diversify their investments into nine asset classes: in the U.S., large growth companies, large value companies, small growth companies, small value companies and short-term bonds; internationally, large growth companies, large value companies, small growth companies, small value companies and companies in emerging markets.

As you can see, questions about investing aren't always as simple as they seem. There are a lot of good articles about investing on my Web site, FundAdvice.com, and I encourage you to browse through whatever interests you in the "Basics of Investing" section of our article library.