Our calculation is based on four steps:
assess how much risk each fund is taking
calculate most likely projected returns given that level of risk
calculate good case and bad case projected returns
allow for diversification between funds in portfolios
Risk and return are inextricably linked because of something called the "risk premium". This is the well recognised effect that, over the longer term, returns on investments are usually higher than the interest rate on savings accounts. It is called the "risk premium" because it's the investor's compensation for taking some risk.
The starting point for our calculation of projected returns on any fund is therefore an assessment of the risk being taken by that fund. This is standard practice in big financial services companies when they're managing their own money.
We use two key indicators to assess how much risk a fund is taking:
Firstly we look at how volatile the fund's returns have been in the past relative to the market as a whole. This is the one place where past performance is actually useful because funds that are taking more risk will consistently have relatively more volatile returns.
Secondly we look at the price of financial "options" which are used by big companies to insure themselves against stock market losses. If the price of these options goes up then it indicates that markets have generally become more risky.
For some types of funds, we also consider indicators such as: the stated strategy of the fund, the sectors it claims to be investing in and the information it discloses about its holdings.
For example, this is sometimes necessary for property funds (where the historic volatility is often artificially low due to accounting practices in this sector) or very new new funds (where there hasn't been enough time to build up a good picture of historic volatility).
However, these sorts of indicators are very crude and open to manipulation by fund managers (eg changing holdings shortly prior to the data of disclosure). We therefore place much more weight on the hard fact of how volatile returns have been in the past.
We can then calculate the most likely projected returns.
Our calculations take full account of charges and the level of risk being taken by each fund. We use the same approach that most big financial services companies use when they are managing their own money which is based on some very simple principles:
We start with the return that you could get by taking no investment risk. This is effectively the rate on a long term savings account.
We add to that the amount of extra return the fund would be expected to generate by way of risk premium, based only on the amount of risk the fund is taking. We make no judgement on the skill of the manager.
We deduct from that the level of charges the fund manager takes plus other expenses incurred by the fund, which will act to reduce the returns.
This approach is somewhat controversial because it tends to favour cheaper funds. The more expensive fund managers would argue that their charges will be more than compensated for by their skill in managing investments. However, most independent studies conclude that this is not the case.
Next we can move on to calculating the good case and bad case returns. We calculate these such that there is a 1 in 6 chance of doing better than the "good case" and a 1 in 6 chance of being worse than the "bad case".
Again, we use the same approach that most big financial services companies use when they are managing their own money which is based on some very simple principles:
We start with the most likely return
We fit a probability distribution around that return based only on the amount of risk being taken by the fund. We make no judgement on the skill of the manager.
Again, this eliminates any need for judgement about the skill of managers or the likely relative performance of different sectors or regions.
When we calculate the good case and bad case returns for portfolios of funds, we also allow for the diversification between those funds.
Diversification - or not putting all your eggs in one basket - is very important because it enables you to reduce risk without having to accept a lower most likely return.
We allow for diversification by looking at the tendency for fund prices to move together, particularly during more extreme market events. We then make an allowance for this effect when we calculate the good case and bad case returns for the portfolio.
For ISAs and Junior ISAs, income and gains are tax free, so this step is not required.
For general investments, we allow for tax on estimated investment income at the basic rate only. There is no allowance for tax on gains.
The actual tax you pay will depend on both your personal financial situation and the actual performance of the investments, so it could be considerably different. The government's money advice service summarises the tax treatment of general investments in unit trusts and OEICs.