If you've ever lost money betting at the horse track, you can probably sympathize with anyone throwing their hands up in despair because their mutual funds' performances didn't place. Indeed, unless you do your homework, some might say that picking a winning mutual fund is such a hopeless endeavor that you might as well throw your money away at the track!
Odds of Winning: One in Five?
We often hear that 80% of managed mutual funds fail to beat the market as measured by the S&P 500. This statistic, however, cannot be taken at face value. In many years, it's true that 80% of funds underperform the market, but the exact percentage of low performers changes every year. According to a study from Jeremy J. Siegel's book "Stocks for the Long Run", the number of funds that - over the 30 years from the 1970s to early 2000s - outperformed the S&P 500, excluding fees, varied between 10% and 85% from year to year. And between 1982 and 2003, there have only been three years in which more than 50% of mutual funds beat the market! So, while it's not technically accurate to say that only 20% of funds outperformed the market, we can say that most of the time, a majority of managed funds will underperform.
Despite this, every year headlines are splattered across financial publications showcasing the spectacular performance of the past year's top mutual funds. How do they do it? Is there a surefire way to choose the best funds? Despite what the financial media would like you to believe, the sad but true answer is "no." Let's examine the top three reasons why there is no guaranteed way to find the best funds.
Reason No.1: The Ever-Changing Behavior of the Market
You buy a mutual fund to have an investment professional manage your money, so you can achieve a higher return than you would on your own. The better the manager, the better your returns. However, even if your fund has a good manager, you could still lose money due to normal cycles within the market. Remember that each mutual-fund manager has specific investment objectives. In any given year, specific sectors and types of investments will perform extremely well while others will perform poorly. Should a sector or class of asset in which the fund's assets are heavily allocated perform well over the year, the fund might be on the winning list. Take for example the Matthews Korea fund, which invests in Korean companies. Its five-year return of 34% as of Dec 2002 gave this fund its second-place rating by Morningstar.
Let's say you invested in this fund when you read about its great performance back in Dec 1999, when the cost per unit was $8. By the end of Dec 2000, you would have, however, lost approximately 69% of your investment, as the fund's units (shares) would be worth around $2.50 a unit! The 34% is only an average: within the five-year period between Dec 1997 and Dec 2002, the Matthews Korea fund saw many ups and downs. Even a great manager is unable able to have strong performance when his or her industry, region or asset class is doing poorly. You must invest for the long term based on a fund's fundamental investment qualities.
Reason No.2: Top Performers Don't Always Stay on Top
Another strategy is to pick the mutual funds with the best current performance. It makes logical sense that the best funds are doing something right, so picking them would give you a better chance to enjoy these gains in the future. Unfortunately, the evidence is to the contrary. A study done by Burton Malkiel in his book "A Random Walk Down Wall Street"compares the performance of the 20 best funds in the 1970s to their performance in the 1980s. All but the Magellan Fund, which was run by Peter Lynch, could not keep up their above-average results. In fact, the top 20 funds not only underperformed the market as time went on, but they also underperformed the average mutual fund. (We should note that Malkiel wasn't just data mining; the study has shown the same results over many time periods).
Why do the winners turn into tomorrow's losers? Some say that fund managers can't deal with the new influx of cash as a fund grows and runs out of ideas. Academics call it "mean reversion", which is the tendency of something to return to its long-term average. Others say that the stellar performance of a fund is based upon pure luck. In a study by Forbes Magazine in the latter part of the 1960s, a selection of 28 stocks was chosen by throwing darts at a paper containing stock names. A sum of $1,000 was invested in each stock, and in the mid 80s, the portfolio grew from $28,000 to over $130,000, a 9.5% annualized gain! Consequently, this "dartboard fund" outperformed the majority of expert portfolio managers!
The following point is driven home with the disclaimer quoted in virtually all mutual-fund prospectuses: past performance is not an indication of future performance. An easy mistake made by many investors is to disregard this disclaimer and succumb to the temptation to choose one of the funds on the winning list.
Reason No.3: So Many Funds, So Little Time
We've talked about how a majority of actively managed funds don't beat the market, how even the good sector funds are at the mercy of the business cycle, and how it's rare to find a top performer who keeps on performing. Still, many hope to find the next Peter Lynch. It's not hard to see why: under his management the Magellan Fund outperformed the S&P 500 index by 13% per year from 1977 to 1990.
Finding the next Peter Lynch, however, is like trying to find the next Microsoft. The odds that you find the next winner are minuscule because of the sheer volume of funds that are available to investors. According to an international mutual funds survey from the ICI Mutual Fund Connection, over 8,300 open-ended mutual funds were available to investors as of Mar 2002, a total of over $7 trillion in assets within the United States alone! Sifting through that many funds and performing a reasonable amount of research on each fund within a reasonable time period is virtually impossible.
Is it Possible to Pick the Winning Funds?
Selecting good funds to hold for the long term has little in common with picking a winning horse at the track if your selection criteria only consist of the horse's name or the jockey's colors. It takes a careful look at a variety of positive fund characteristics - the quality of the fund company, style consistency, long-term management tenure, low expenses, low portfolio turnover and appropriate asset size - to make an informed selection of a managed mutual fund. As an alternative to this process, many investors find index investing less complicated and just as rewarding. Although being average is boring, many investors are best off minimizing their funds fees and expenses by putting their investing on autopilot with low-cost index funds.