BOSTON – Most investors buy into mutual funds based largely on good past performance and then sell those funds due mostly to disappointing results. It's a sad pattern bound to repeat itself if performance alone is your driving factor in fund selection.
According to the latest Standard & Poor's Mutual Fund Performance Persistence Scorecard, you have little reason to believe that a fund that is a top performer today will maintain its edge tomorrow. That's hardly new information, as researchers have known for years that funds tend to lead the pack when the asset classes they own are hot but fall back as the market cycle turns.
The S&P study focused on domestic equity funds and not more volatile offerings like sector and international funds. And it clearly points investors away from chasing the best recent performers because they're not likely to be kings of the hill for long.
According to the study, just 15.5% of large cap funds were able to maintain a spot in the top 25% of their peer group over three consecutive years. The numbers get worse when you look at midcap funds (10.2%) and small-cap funds (9.8%).
Over five years, just 1.9% of funds buying large-company stocks were able to maintain a top-quartile ranking, compared with 3.1% of small-cap funds and no midcap funds whatsoever.
The results are better when a fund merely needs to maintain its standing in the top half of its peer group. Roughly one-third of all large-cap funds consistently were in the top half of performance, results that were slightly better than for funds invested in smaller stocks.
The good news is that in all cases, your chances of picking the rare fund that remains consistently outstanding are better than the chance that randomly throwing darts at the fund tables would pick you a superior performer.
The bad news is that if you pick a high-flyer, you need to expect that it may lose some altitude.
One interesting side note to the performance measurement is that funds that are among the very worst performers tend to stay there, frequently burdened by heavy costs and poor management. So while picking from the top of the fund pool is not necessarily going to deliver a long-term winner, it's a better bet than taking the contrarian approach, selecting a dog and hoping it becomes a big winner.
"A lot of times, investors are attracted to the wrong things because they are using performance as their first screen," says Jeff Tjornehoj, a research analyst for Lipper Inc. "What they want is consistently above-average returns, but what convinces them to buy is top-quartile or top-decile performance over the last year or two. A lot of funds that are best over the long haul don't ever break into that very top group in any one-year period, they are just good and above-average year after year after year."
What the S&P study shows is that the funds that are capable of remaining at the top of their peer group have a few elements in common, most notably low costs, long-tenured managers and the ability to minimize losses when the market turns sour.
"People who focus excessively on past performance most likely will be unhappy with their fund, because it's so hard to maintain that performance, especially if the fund has done well in the year or two before it was purchased," says Srikant Dash, an index strategist for Standard & Poor's and one of the researchers behind the study. "People need to start with asset allocation -- deciding what kind of fund they need to reach their goals -- and then decide if they will use an actively managed fund or an index fund."
"Once those judgments are made, the investment decision should be about those other factors, like expenses," Dash adds. "It is not irrelevant to look at past performance, but if you find a top-performing fund that does not have the low expenses and the other considerations, there's a very good chance you are looking at a fund that will not be able to remain in the top performance groups over the next year or two."
In short, with past performance as the primary guide, you're likely to be disappointed in the results the fund achieves for you.
Says Tjornehoj: "A good fund is known by its above-average performance, not necessarily from being at the front of the pack in each period. If investors set their expectations as 'above-average over time,' they are much more likely to be satisfied than if they buy a fund at the top of the heap and expect it to stay there."
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