Most mutual funds and exchange-traded funds (ETFs) disclose that past performance does not guarantee future results. This gives investors a fair warning that what has happened in the past is unlikely to happen in the future. However, one of the most popular selling points of mutual funds in advertisements is their past performance. They understand that investors are enticed by strong returns, and they often use these numbers when they are deciding where to put their money.

As a result, many of the most popular mutual funds are the ones that have delivered above-average returns in the past. However, as the disclosure states, what happened in the past is not necessarily what will happen in the future.

Fidelity Magellan's Rise To Prominence

Consider the Fidelity Magellan Fund (FMAGX), for example. Peter Lynch is generally the fund manager credited with bringing Magellan (and Fidelity in general) to prominence. Lynch took over the $20 million Magellan Fund in 1997; during his 13-year tenure as the fund's manager, he delivered an average annual return of 29.2%. When Lynch departed in 1990, the fund's assets under management (AUM) had ballooned to $14 billion.

Clearly, Magellan had become one of the most popular mutual funds in the world following Lynch's tenure. However, in the mutual fund world, past performance is tied to the fund's management team and not the fund itself. Once Lynch left, his past performance record went with him. For all intents and purposes, Fidelity Magellan was starting from square one with a new fund manager.

Morris Smith and Jeff Vinik took control of Magellan from 1990 through 1996. During their time at the helm, Magellan underperformed the Standard and Poor's (S&P) 500 Index five of the seven years. By the time Vinik left the fund, AUM rose from $14 billion to $50 billion. Many investors piling into the fund in the 1990s were hoping for or even expecting Lynch-era returns, only to find that their investments were largely failing to stay ahead of the S&P 500 Index. Robert Stansky's subsequent tenure fared only modestly better, beating the S&P 500 in four of his nine years as lead manager and producing a 238% total return for the fund, trailing the S&P 500's 274% return.

By the end of the century, Fidelity Magellan became the largest mutual fund in the world, with assets of over $100 billion. By the end of Stansky's time in 2005, the fund's post-Lynch track record began catching up with it, and its assets shrunk back down to $52 billion. As of Sept. 30, 2015, fund assets stand at just $14.8 billion.

The Dangers of Chasing Past Returns

The tendency of investors to chase past returns is further cemented in the actual returns that people experience. Investors are taught to buy low and sell high, but behavioral finance teaches that the opposite often occurs. People see strong past performance and others investing in a hot investment and end up buying at a high price. Once the fund starts underperforming, these same investors seek to exit their positions to avoid what they perceive will be further losses.

An example of this would be the tech bubble of 1999-2000. Investors bid up tech stocks to extreme overvaluations, trying to jump on the bandwagon. Many jumped on board just in time to see the bubble burst and watch their investment values plummet suddenly.

Investor Returns Often Trail a Fund's Total Return

Fidelity Magellan demonstrates a similar trend. Mutual funds quote average annual returns in their fund literature, but these returns assume that an investor owns a position on Jan. 1 and holds the position until December 31. Many investors buy and sell during the year and often do so in the "buy high, sell low" mentality.

As of Oct. 31, 2015, Fidelity boasted a 15-year average annual return of 2.88%. The average annual return of a typical investor during that same time frame was actually -1.63%. That means the average investor is trailing the fund's overall return by over 4% a year thanks to buying and selling activity over time.

Conclusion

There is no good way to forecast whether a fund will outperform in the future. Investment dollars tend to follow strong past performance, and these funds tend to become the popular funds at the time. However, there are so many factors to take into account that there is no evidence that the popular funds will outperform a given benchmark going forward.

When choosing a mutual fund for investment, past performance should be just one piece of information to consider, but it should be far from the main piece. The fund manager in place will be a better indicator of whether a fund has the potential to outperform in the future. If a fund manager has demonstrated the ability to consistently outperform its chosen benchmark over time, like Lynch has, then the chances of outperforming the index could be considered greater – but that also is no guarantee of the fund's future performance.

The best funds for any given investor will be unique. Appropriate funds are generally those with lower expense ratios. For example, index mutual funds often charge razor-thin expenses, and paying lower fees on investments directly correlates to better overall returns over time.

Also, investors should fill out their portfolios with funds that correspond to an appropriate asset allocation. Younger investors can often tolerate a greater level of portfolio risk due to the long-time horizon they will have to ride out any short-term market fluctuations. This generally leads to a higher allocation to stocks, whereas an investor in his retirement years is more likely to need a greater percentage of bonds and money market funds in his portfolio to generate a monthly income.

Choosing the largest and most popular funds could lead to portfolios with asset allocations inconsistent with what an individual should be invested in, given his personal situation and his risk preferences. Following these general guidelines can yield a greater likelihood of success than chasing popular funds alone.

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