Chances are that the last time you bought a fund, your selection was based in no small part on recent performance, star ratings, the manager’s tenure with the fund and the fund’s popularity and reputation.
And that may be why now, some time later, you aren’t so thrilled with your decision.
A new study on fund performance issued this month by Financial Research Corp. in Boston shows that many of the traits investors use to select funds actually lead to mediocre results.
This is not necessarily a surprise. For years, it seems, the entire fund industry has warned against chasing performance and buying hot funds, and had studies to back up the claims.
But the new study does highlight how investors rely on data that tends to lead them astray in the future. Here are the study’s most critical findings:
– Past performance is a lousy indicator of what’s ahead.
The top 10 percent of funds in any 12-month period since 1988 dropped, on average, to the 48th percentile during the following year. Roughly half of the time, those funds were below-average performers within a year of scaling the fund summit.
At the same time, roughly 40 percent of the worst performers in any given year put up above-average gains during the 12 months after bottoming out.
In other words, funds tend to regress toward average performance, which is a big reason to consider carefully whether you want to jump into any fund trumpeting its recent gains.
– There is no real difference in how funds with three-, four- or five-star ratings from Morningstar perform in the future.
The ratings system of Chicago-based Morningstar was never meant to be predictive. It is essentially a gauge of how much a fund earned, relative to the risks it took to make that money and compared to the performance of similar funds.
It is based on past performance which, as already noted, doesn’t make for great forecasting.
The Financial Research study points out that, on average, funds with three stars outperformed five-star issues in 1995, 1996 and 1997. Four-star issues had the best aggregate performance of the group, though even they lost out to funds that were too young to have gained a Morningstar rating.
Yet more than 90 percent of all new fund investments go into issues that have Morningstar’s two highest ratings.
“It’s not that star ratings are bad,” explains James Crandall, a Financial Research analyst, “but they don’t predict how a fund will do downstream and people should not be thinking that a good rating today means great returns in the future.”
– Size matters, but bigger isn’t better.
Over the last decade, according to Financial Research, the smallest 25 percent of funds has outperformed large funds in four of every five years.
Many past studies have shown that younger funds tend to outperform their older peers. The new study came to the same conclusion, but cited the cause as the small asset size a new fund has when it starts out. If the assets balloon quickly, the young funds lose their edge, because they are susceptible to the same problem with heavy net sales as are the old-timers.
– A fund’s long-term track record can dramatically overstate the performance investors actually have gotten in the fund.
Because investors typically buy after funds earn big returns and grow popular, they typically buy in at the wrong time. When the fund proceeds to regress to the mean, the investor winds up with a portfolio of big-name funds producing mediocre returns.
Ironically, the trap of overreliance on performance data at least gives investors an excuse when a fund underperforms in the future. They can say, “It looked like a good fund.”
Says Crandall: “Success in a fund is hard to predict. You really need to look at a fund more for how it operates and how it has been managed than for what kind of returns or star ratings it has had lately.”
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Charles A. Jaffe is mutual funds columnist at The Boston Globe. He can be reached at The Boston Globe, Box 2378, Boston, Mass. 02107-2378 or by e-mail at jaffe@globe.com.
