If picking mutual funds were as simple as buying those with the best recent performance, accumulating wealth would be a cinch. Pretty soon, we’d all be billionaires. While this is obviously impossible, too many investors continue to chase performance. Mostly, that chase is in vain.

Most investment literature, including that on this Web site, contains standard disclaimer language to the effect that past performance doesn’t necessarily predict the future. The language is legally required to make sure investors don’t get the idea that the past somehow guarantees the future. Most investors have enough sense to know this, of course. Yet in real life, they can’t seem to resist acting as if the past in fact DOES predict the future. One of the most predictable events along Wall Street is what happens to whatever mutual fund has the highest performance in a calendar year. Inevitably, new money flows fast and furiously into that fund. No matter that a calendar year has no intrinsic meaning and is only a convenient convention. No matter that the fund can’t possibly deploy new investments exactly the way it invested previous ones. And no matter that the very act by investors of building up a fund’s size may diminish the fund’s chances of repeating the performance that attracted all the new money.

Nope, when investors see hot performance, especially performance that coincides with a calendar year, they just abandon good sense and take the plunge, hoping to ride the coattails of that performance. And the mass media are willing accomplices. Forbes, Money, Business Week, Kiplinger's Personal Finance Magazine and others have found a perennial gravy train. The drill goes like this: List a few thousand mutual funds, find some way to rank them on performance and risk, write a few articles about the hottest performers and crown those stars as "the best."

Readers snap up those special mutual fund issues, eager to see how their own funds compared with "the best." Often, those readers invest new money or even switch out of their current investments into the newly anointed crown jewels of the industry.

A screwy way to invest

We have thought for some time that this is a screwy way to do things. Each publication seems to come up with its own "best" fund lists, often with little overlap. This makes us think some investors are picking publications on which to rely instead of picking funds.

But forget what we think. Let's look at the facts. If this were a good way to invest in mutual funds, the results should be obvious. We decided to test this out by following the results of five mutual funds described as "the best" by Worth magazine in November 1994. Worth didn't actually recommend these funds to its readers, but the magazine cover came pretty close, identifying the five as the stock funds "with the best prospects in their investment categories right now."

Therefore, we think it's fair game to see how readers might have fared if they had put their money in those funds soon after that article hit the streets. If Worth was right, those five funds should have been at least above-average performers in the next few years. Table 1 below presents two and a half years of performance data for the five funds. As you'll see, a portfolio equally weighted in the five Worth-picked funds was up 62.7 percent from January 1995 through June 1997, equivalent to a 19.6 percent annualized compound rate of return. That's fine performance by historical standards, but it doesn't necessarily stand out during the roaring bull market we've been experiencing.

Worth's article included photos of the five fund managers, each of whom was characterized as particularly savvy at picking stocks. I'm sure those managers are competent, capable and dedicated people. But I can't help thinking how humiliating it must be to them and to Worth's editors to learn that in four out of five cases, Worth's top-ranked mutual funds failed to even match an index of all the stocks in their categories over the next two and a half years. Imagine, being touted as a stockpicking guru, only to lose to an index fund!

Boring is Better

Without shame, we recommend index funds as the way buy-and-hold mutual fund investors are likely to get the most for their money. However, you should be warned: Index funds are boring. If you invest in an index, you'll never be able to brag about the stockpicking genius of your portfolio manager or the interesting "themes" your fund has adopted to take advantage of business trends. Your fund has almost no chance of making it to the top of the performance charts or being chosen among "the best" by any financial publication.

But if you're willing to bet on boredom, you may win. In the table, right below each of the Worth picks is the corresponding Dimensional Fund Advisors index or passive asset class fund. These DFA funds are not available to the public except through investment advisors (we use them as part of The Ultimate Buy-and-Hold Strategy for our private clients). But they show how each relevant class of assets did over the two and a half years. If you're managing the portfolio of a mutual fund, you'd better at least beat the unmanaged average of stocks in your asset class. Otherwise, your job could be in jeopardy because you're not adding any value to shareholders in return for your pay. Yet in all but one case, the DFA fund beat the Worth featured fund.

Why did this happen? Was this just an isolated incident? We don't think so. Worth's editors did the best they could, using reasonable criteria for choosing the best funds. The portfolio managers did their best to be worthy of the accolades the magazine bestowed on them. But "the best" simply was not good enough, because the past was all that the Worth editors had to base their judgments on. And the past simply does not determine or predict the future.

Worshipping false gods

We’re not just making this up. We checked it out. Those who worship the gods of performance seem to think that the funds with the best performance over the past five years (or over some other period) are likely to continue that top performance over the next five years. That seems perfectly reasonable and logical. The only trouble is that it just ain’t so.

How to verify this? Take a look at Table 2 below. So that we could use a period of five calendar years, we started by listing the 10 top performers among aggressive U.S. stock funds for the five years 1987 through 1991, according to Sheldon Jacobs’ Handbook For No-Load Investors. We then tracked those funds for the subsequent five years, 1992 through 1996. These funds, by the way, include some famous names: Janus Twenty, Twentieth Century Giftrust, Fidelity Contrafund, Twentieth Century Ultra, Berger One Hundred. These 10 funds had averaged 22.6 percent compound rates of return for ‘87 through ‘91, 75 percent better than the 12.9 percent average for their category. But for the next five years, the same 10 funds averaged just 13.9 percent, barely ahead of the average of 13.5 percent for aggressive growth funds. Bottom line: Five years of outstanding performance doesn’t help identify the next five-year winners.

Next, we wondered if a decade of past performance might give a better clue to the future than only five years. So we checked it out, identifying the top 10 aggressive growth funds ranked by performance for a full 10 years, 1982 through 1991. Surely, we reasoned, these funds must be seasoned performers, able to do something right and do it over a sustained period. But in fact, defying logic, this turned out to be an even worse guide to the upcoming five years.

This group of 10-year stars averaged an impressive 19.5 percent over the 1982-1991 decade, far above the category average of 12.0 percent. So how did these 10 funds do from 1992 through 1996? Not one averaged even 18.5 percent, and the average for the 10 was only 12.9 percent, lower than the category average of 13.5 percent.

Four of these 10 funds beat the category average, and we wondered whether or not past performance might have helped us identify them at the start of 1992. We found five funds that were in both lists, the top performers for five-year and 10-year periods ending in 1991, and thought maybe they would be among the true standouts of the future. Alas, this screening gained us almost nothing, as you’ll see in Table 2.

In all cases, the past performance winners turned out to be only about average for the subsequent five years. I hope you’ll remember this the next time you thumb through an annual mutual fund issue of your favorite financial magazine and you’re tempted to jump on the performance bandwagon.

What’s an investor to do?

All this is enormously frustrating for mutual fund investors, most of whom want performance more than anything else. The one thing that funds can advertise, past performance, is the one thing investors can’t buy. All you can buy is the future, which of course is unknown.

So how do you pick mutual funds?

•You could be a contrarian and buy the funds with the worst performance records. Sometimes, that can be a productive strategy. But few investors have the stomach for methodically investing in proven losers, and we can’t recommend it.

•You could pick funds based on magazine recommendations, flashy advertisements, re-assuring marketing materials or high ratings from companies like Morningstar and Value Line.

•Or you could just throw up your arms and buy what a salesman suggests. Most likely that will be a load fund on which you pay a commission. That means 2 to 6 percent of the money you pay for the fund never gets invested. It just goes to the salesman.

I don’t think any of those methods will reliably lead you to top-performing funds. In fact, I don’t think there is any way to reliably identify in advance the top performers. Remember, if it could be done, everybody on Wall Street would already be doing it.

So here are my suggestions if you want to be a savvy fund-picker.

•First, adjust your expectations. Don’t even try to identify and buy "the very best" funds in advance. This exercise is mostly futile, as we have seen, and it can lead you astray more often than it leads you down the right path.

•Second, decide if you’re going to use a market timing approach or a buy-and-hold approach.

•If you want to use market timing, choose funds from our Model Portfolios. These funds have proven track records. They are required to stick to certain asset classes. They have above-average performance and below-average costs. And they allow in-and-out trading by market timers. Use our timing models to govern your purchases and sales. Because of the timing, your results won’t look like those of the market as a whole. But over long periods, we think you can have higher returns with lower volatility than if you bought those funds and held onto them.

•If you’re a buy-and-hold investor, I cannot think of any reason to invest in actively managed mutual funds instead of index funds. Index funds tend to perform in the top 25 percent of their asset classes. They have low expenses and low turnover, which means lower tax bills for investors.

In our Ultimate Buy and Hold Strategy, we use Dimensional Fund Advisors institutional asset class funds. These funds, available through hundreds of investment advisors, including us, are the best way we know of to participate in the long-term upward movement of markets without worrying about when to buy and when to sell. If you don’t have $100,000 to invest, you can build a similar portfolio from readily available mutual funds. You can pick among funds available at little or no cost from Vanguard, Fidelity and the discount brokerage run by Schwab.

Ideally, we think you should carefully balance the equity part of your portfolio to include nine asset classes: large growth stocks, both U.S. and international; large value stocks, both U.S. and international; small growth stocks, both U.S. and international; small value stocks, both U.S. and international; and stocks of all sizes in emerging markets. The result can be an enviable combination of higher returns and lower risk.

The critics of index funds say they’re risky because they can go down if you don’t watch them. But that is true of any investment. And as soon as you start "managing" funds by selling in a downturn, you have ceased to be a buy-and-hold investor. You have become a market timer without a discipline.

Index funds are ideal for true buy-and-hold investors, but they’re not suitable for market timers because these funds can’t afford to get in and out of the markets at the whim of their shareholders who are using timing. DFA, in fact, turns away accounts in its funds when it doesn’t believe the investors or their advisors are serious about taking a buy-and-hold approach.

Investing in index funds may be relatively boring, and you’ll never win your friends’ admiration for your fund-picking ability. But the returns might make up for that. Just for fun, we decided to track 1992-1996 results for the DFA index fund in small-cap domestic stocks. That’s a close equivalent for the aggressive growth funds. Over those five years, $100 grew to $184 in the five funds at the bottom of Table 1, those with superior records over both 5-year and 10-year periods. In the same five years, $100 grew to $243 in the DFA small-cap index fund. That’s a 32 percent performance boost just from using an index fund.

The bottom line: If you’re comfortably invested in the right index funds for the long term, you can safely ignore the magazine headlines such as "The Funds You Should Buy Now" – or read them just for amusement.

 

 

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