The statement, “Past performance does not guarantee future results,” appears on all mutual fund literature. Since we see it so often, however, it is easy to ignore. Yet the disclaimer is as pertinent as ever. Simply picking funds that have been on top rarely leads to strong additional gains.
As professional investors, our firm sees new clients who come to us with some strange notions about investing. People can be naïve or easily forget lessons of the past. While not relying on past performance seems like a pretty basic caveat, remembering why rear-view-mirror investing is flawed is important, and understanding how a professional’s approach is likely to give you new insight into our job in working with you.
Failure To Repeat. Consider the results of a January 2007 study by Standard & Poor’s analyzing mutual fund performance during the five-year period ended Dec. 31, 2006. It showed that good performers one year often fail to repeat the next year.
The study evaluated large-cap, mid-cap, and small-cap funds, measuring how well each actively-managed fund performed relative to others in its class. To gauge performance, funds were grouped into quartiles. A fund that outperformed three out of four funds in its group would rank in the top 25%, or quartile, while a fund that lagged three out of four would be in the bottom quartile.
Only 13% of large-cap funds ranked in the top two quartiles of that class for each of the five years. Just 10% of mid-cap funds and 10% of small-cap funds ranked in the top two quartiles of that class for each of the five years.
Researchers then raised the bar to see how many funds ranked in the top quartile every year for five years. A mere 3% of large-cap pulled this off. Only 2.5% of mid-cap funds and none of the small-cap funds were ranked in the top quartile every year in the five-year period studied.
Of course, just because a particular fund falls out of the top ranks occasionally doesn’t make it a bad investment. But the inability of the vast majority of funds to stay on top underscores the difficulty of choosing a fund based only on its record.
A fund that has done well may have succeeded for a variety of reasons. Maybe it had a great manager, or maybe it got lucky because it happened to be operating in a particularly hospitable environment. In 1999, lots of technology funds had great records. However, investors who jumped into those funds soon wished they hadn’t, after the tech-stock bubble burst. A fund’s long-term record, though it can be helpful in evaluating its future prospects, is only one of numerous factors to consider when selecting funds.
Selecting Funds. One way to approach fund selection is to think of it as hiring a new employee. The fund manager you select will work for you, collecting a fee in return for trying to build the value of your investment. And while screening funds is not the same as personal interviews with managers, exploring a manager’s areas of specialization, track record, and investment style is informative. Some other factors we consider included:
Whether the fund manager deviated from the fund’s strategy—for example, if it’s a government bond fund, does the manager sometimes buy riskier high-yield bonds or growth stocks to boost returns? How much of the fund’s portfolio was involved? How much money is flowing into the fund? Often, funds get popular after they’ve been successful. But a flood of new money can overwhelm a manager and cause performance to drag. How has the manager responded when the fund’s investments are out of favor? Has he managed to eke out a positive return even during tough times? Or is his style to stay fully invested? This could affect your asset allocation and needs to be anticipated. Other factors to consider include the fund’s expense ratio, tax efficiency, trading history, the team surrounding the fund manager, and the fund company’s reputation. Past performance is a factor in the selection process, but primarily as a tool for evaluating the manager. Consistent returns, for example, could indicate a steady management style that does not chase fads. Rather than considering returns alone, it helps to compare the fund’s track record with an appropriate benchmark. How did the fund performance stack up against an index of large-company stocks, for instance?
Fund selection is also influenced by economic factors or the prospects of a particular sector. While market timing has been shown by many studies as ineffective, looking for investments that are out of favor or asset classes that are selling at prices below their historical valuation could present opportunities.
The bottom line is that a fund’s past performance doesn’t ensure returns in the future. A manager’s track record, consistency, methodology, and experience must be considered, but these factors are only part of the equation. Fund selection depends on your personal needs, tax situation, and other portfolio holdings. Rather than just looking into a rear-view-mirror at past performance, the investment outlook and your personal factors will probably be more important in selecting the funds right for you. Always read a fund's prospectus before investing. | 
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