Want to own a mutual fund that will double its reported return in the next six months? Chances are, you already do.
 
Every equity mutual fund on the planet is about to report a big jump in its five-year performance. That’s not a prediction; it’s a mathematical certainty—unless the market crashes.
 
The Spike in Five-Year Performance…
September 13, 2013 is the fifth anniversary of Lehman Brothers’ bankruptcy, an event that drove prices of almost every asset class except U.S. Treasuries off the cliff. For example, the Standard & Poor’s 500 Index tumbled from 1,287.83 on September 1, 2008 to 902.99 by the end of that year—and to 729.57 on March 1, 2009. The starting point for the five-year track record of equity mutual funds is about to nosedive, which means reported performance will soar.
 
Suppose the U.S. equity market moves sideways for the next year. A Standard & Poor’s 500 index mutual fund (or ETF) that has a cumulative 65.7% return over five years through July 31, 2013 will see its reported five-year return jump to 87.1% by year end and to 131% by March 2014—even though nothing has changed except the starting date.

SEE: Measure Your Portfolio's Performance
 
Won’t Last…
The performance spike will be fleeting, though. It will begin to unwind during the second quarter of 2014 and be over by year-end. On July 1, 2014 a flat market from July 31, 2013 will represent an 83.5% return over five years, and the number will taper off to 60.1%% at October 1 and 51.3% by December 31.
 
Each equity mutual fund has a unique track record, but no matter what strategy it pursues, which segment of the market it focuses on or whether it does better or worse than the Standard & Poor’s 500 index the reported results will trace a similar pattern.
 
It’s an Illusion…
The rollercoaster ride demonstrates the danger of relying on performance alone when picking a mutual fund. Other factors that are, or should be, more important, including what investment strategy the fund pursues, manager tenure, the risk profile, assets under management and what role the fund plays in meeting an investor’s objectives.
 
Performance can help investors pick from a shortlist of funds that meet their other criteria, but it should be taken with a pinch of salt and in proper context. How did the fund perform relative to its benchmark? Or its peers? Is the starting point of the measurement period at a market peak or trough?
 
Right now, investors tracking five-year performance are like a person on the observation deck at Rockefeller Center (on the 70th floor), who must look up another 38 stories to see the top of the Empire State Building. Relative to where the person is standing, the additional height is obvious, but comparable to any number of skyscrapers in mid-town Manhattan seen from street level. If he or she takes the elevator down and looks up from the street, the Empire State Building towers above its puny siblings. The building hasn’t changed, but the observer’s frame of reference has altered the perspective.
 
Investors looking at five-year performance will take that ride down over the next six months—but then get right back in the elevator and return to the 70th floor vantage point by the end of next year.
 
That Could Confuse Investors…
Investors who study performance when picking mutual funds often attach more weight to longer-term results. Provided the performance was not concentrated in one or two years, a five-year record that trumps whatever benchmark the fund uses suggests the manager’s performance was not a fluke. A 10-year record will likely include both bull and bear markets, showing how the manager performs through an entire market cycle, too—but many mutual funds do not have a 10-year record, let alone under the same portfolio manager.

SEE: How To Pick A Good Mutual Fund
 
In the coming months, however, investors should beware of sales pitches touting funds that have “doubled over five years.” In fact, any U.S. equity fund that does not make this claim by next March, the five-year anniversary of the market bottom, will have lagged the market by a country mile.
 
Who Should Focus on Other Periods
While an arithmetic aberration sends five-year performance numbers to the moon and back, it will have no effect on reported performance for shorter and longer measurement periods. Investors reviewing mutual fund performance during the next year or so should pay more attention to the one-, three- and 10-year numbers and ignore—or at least downplay—the distorted five-year record.

Related Articles
  1. Mutual Funds & ETFs

    Mutual Funds: Does Size Really Matter?

    The growth of mutual funds isn't always cause for celebration. Read on to find out why.
  2. 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.
  3. Mutual Funds & ETFs

    An Introduction To Sector Mutual Funds

    Investing among several different sectors in the economy is a way to diversify your portfolio.
  4. Mutual Funds & ETFs

    Socially (Ir)responsible Mutual Funds

    Not concerned about being an ethical investor? Maybe "sinful stocks" have a place in your portfolio.
  5. Mutual Funds & ETFs

    Analyzing Mutual Funds For Maximum Return

    Using a few simple metrics will help you pick the right fund for your portfolio.
  6. Mutual Funds & ETFs

    Top 3 First Pacific Advisors Funds for Retirement Diversification in 2016

    Learn about three mutual funds from First Pacific Advisors for including in a well-diversified retirement portfolio. Discover which fund truly stands out.
  7. Mutual Funds & ETFs

    Top 3 UBS Global Funds for Retirement Diversification in 2016

    Learn about UBS's asset management business, past mutual fund performance and the top three UBS mutual funds to consider for retirement diversification.
  8. Mutual Funds & ETFs

    Invesco’s Top Funds for Retirement

    Here's a list of Invesco investments—retirement funds—that may work for you if you have the time to let them mature over the long term.
  9. Mutual Funds & ETFs

    Top 4 Royce Funds for Retirement Diversification in 2016

    Discover four of The Royce Funds mutual funds suitable for diversifying retirement portfolios that focus on investing in small-cap companies.
  10. Mutual Funds & ETFs

    Top 3 VALIC Funds for Retirement Diversification in 2016

    Learn about the VALIC fund family, its performance relative to its peers and the top three VALIC funds to consider for retirement diversification in 2016.
RELATED FAQS
  1. How do I find mutual funds that track indexes?

    The two best sources for finding index funds are Fidelity Investments and Vanguard.Of the 57 index funds in investment research ... Read Full Answer >>
  2. Do hedge funds and mutual funds invest in commodities in high inflation environments?

    Hedge funds and mutual funds are very different types of investment vehicles.The contents of a hedge fund are determined ... Read Full Answer >>
  3. Why do some closed-end mutual funds trade above or below their net asset values?

    Intuition tells us that a mutual fund's net asset value (NAV) (the net value of all assets within the mutual fund's portfolio ... Read Full Answer >>
  4. How do segregated funds differ from mutual funds?

    Mutual funds are investment vehicles that many investors have embraced as a simple and relatively inexpensive method for ... Read Full Answer >>
  5. Is it possible to buy mutual funds using a margin account?

    Because of the pricing/trading mechanisms used with mutual funds, they cannot be bought and sold like stocks. When trading ... Read Full Answer >>
  6. How liquid are BlackRock mutual funds? (BLK)

    BlackRock, Inc. (NYSE: BLK) mutual funds are very liquid, as are all mutual funds. An investor receives payment for a redemption ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center