We’ve all heard that ubiquitous warning: “Past performance does not guarantee future results.” Yet looking at a menu of mutual funds in, say, your 401(k) plan, it’s hard to ignore the ones that have crushed the competition in recent years.

On one level, it makes sense that the one-year or five-year returns of a fund tend to carry a lot of weight. Unless investors have the time and wherewithal to investigate each basket of securities on their own, they’re likely to rely on the information that’s right at their fingertips.

But are historical outcomes a good indicator of results down the road? The data would seem to indicate otherwise. One study looked at mutual-fund data over a 16-year period and found that just 7.8% of the top 100 fund managers in any given year retained that distinction the following year.

A separate report by Standard & Poor’s showed that only 21.2% of domestic stocks in the top quartile of performers in 2011 stayed there in 2012. And slightly more than 7% remained in the top quartile two years later.

Subsequent Performance of Mutual Funds in the Top Quartile in 2011

Source: Standard & Poor’s

History Often Doesn’t Repeat

Why are past results so unreliable? Shouldn’t star fund managers be able to replicate their performance year after year?

Certainly, some actively traded funds beat the competition fairly regularly over a long time period. But the inherent unpredictability of the market means that even the best minds in the business will have off years.

A study by investment firm Robert W. Baird & Co. looked into this phenomenon. What the company found was that, even among fund managers who outpaced the market over a 10-year span, many experienced two- or three-year stretches where they trailed the pack.

Translation: If you’re looking at a fund's recent outcomes and the numbers look unimpressive, it’s hard to tell if it’s a bad manager having a bad year or a good manager having a bad year.

There’s an even more fundamental reason not to chase high returns. If you buy a stock that’s outpacing the market – say, one that rose from $20 to $24 a share in the course of a year – it could be that it’s only worth $21. And once the market realizes the security is overbought, a correction is bound to take the price down again.

The same is true for a fund, which is simply a basket of stocks or bonds. If you buy right after an upswing, it’s very often the case that equilibrium is about to bring it back down.

What Really Matters

Rather than looking at what happened in the past, investors are better off taking into account the various factors that do influence future results. In this respect, it might help to learn a lesson from Morningstar, one of the country’s leading investment research firms.

Dating back to the 1980s, the company assigned a star rating to each fund based on risk-adjusted returns. However, research showed that these scores demonstrated little correlation with future success.

Morningstar has since introduced a new grading system based on five P’s: Process, Performance, People, Parent and Price. With the new rating system, it’s looking at the fund’s investment strategy, the longevity of its managers, its expense ratios and other relevant factors. The funds in each category earn a Gold, Silver, Bronze or Neutral rating.

The jury’s still out on whether this new method will fare any better than the original one. Regardless, it’s an acknowledgment that historical results, by themselves, tell only a small part of the story.

If there’s one factor that does consistently correlate with strong performance, it’s fees. This explains the popularity of index funds and ETFs, which, at a much lower cost than actively traded funds, mirror a market index.

According to Vanguard, a whopping 68% of large-cap value funds trailed their benchmark over the past 10 years. What this shows is that, given the complexity of stock movements, it’s hard even for skilled managers to pick enough winners to make up for the higher price tag of their funds.

The Bottom Line

It’s tempting to judge a mutual fund based on its recent returns. But if you really want to pick a winner, look at how well it’s poised for future success, not how it did in the past.

Related Articles
  1. Mutual Funds & ETFs

    4 Strategies For Managing A Portfolio Of Mutual Funds

    Discover some common strategies to devise a plan and maintain your holdings to reflect it.
  2. Retirement

    Are Mutual Funds A Relic?

    We list some options other than mutual funds for your retirement plan.
  3. Investing Basics

    Understanding Stocks, Mutual Funds And ETFs

    Three common products, mutual funds, exchange traded funds and equities are similar but function very differently in a portfolio.
  4. Retirement

    The Hidden Costs Of Investing In Mutual Funds

    Find the hidden fees in your portfolio, so that you can increase your rate of return.
  5. Mutual Funds & ETFs

    An Introduction To Sector Mutual Funds

    Investing among several different sectors in the economy is a way to diversify your portfolio.
  6. Active Trading

    Morningstar's Trifecta: An Easy Way To Select Mutual Funds

    These three pieces of Morningstar's trifecta can help you understand the quality of mutual funds.
  7. Investing

    Time To Graduate From Mutual Funds?

    A few years ago, newly arrived investors were warned that they would lose $10,000 before they learned enough to make any money. If possible, that's not pessimistic enough.
  8. Mutual Funds & ETFs

    Introduction To Money Market Mutual Funds

    Learn about the easiest way to benefit from money market securities.
  9. Mutual Funds & ETFs

    Luck Is The Key To Success For Most Top Mutual Funds

    Without luck virtually all actively managed funds would lag indexes: study.
  10. Mutual Funds & ETFs

    Analyzing Mutual Funds For Maximum Return

    Using a few simple metrics will help you pick the right fund for your portfolio.
  1. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  2. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  3. Do financial advisors get paid by mutual funds?

    Financial advisors are reimbursed by mutual funds in exchange for the investment and financial advice they provide. A financial ... Read Full Answer >>
  4. Why is fiduciary duty so important?

    Fiduciary duty is one the most important professional obligations. It basically provides a much-needed protection for individuals ... Read Full Answer >>
  5. When are mutual funds considered a bad investment?

    Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high ... Read Full Answer >>
  6. Why do financial advisors have a fiduciary responsibility?

    Financial advisors governed by fiduciary duty are bound by law to act in the best interests of their clients at all times. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!