How to Use Mutual Fund Performance

by Neal Frankle, CFP ®

Mutual fund performance is grossly misunderstood, and as a result investors lose money unnecessarily. If you own mutual funds, you deserve to own the best performers. I don’t think I’ll get any argument from you on that. The question is how do you use performance data to find them?

Some people argue that since most mutual funds don’t beat the S&P benchmarks, you’re better off to purchase index funds and ETFs that mirror the S&P and be done with it. (Read “ETFs vs. Mutual Funds.”)Mutual Fund Performance

There is some logic to this argument, but I believe that with a little work, you can do far better. First, I’ll tell you what not to do, then I’ll explain a method you may find helpful.

Many people rely on a rating firm called Morningstar. But my experience tells me that using a Morningstar rating might work sometimes, but other times it could lead to disaster. The reason is that Morningstar awards “stars” based on three and five-year performance. That’s ancient and misleading. The best example of this is provided if you look back to 2000. At the time, the tech stock funds had the highest rankings because their performance over the prior three and five years was through the roof. Had you simply followed the advice of Morningstar and invested in high-tech funds, you would have lost a ton of money.

But from 2000 through 2002, tech stocks plummeted. You didn’t need to be a genius to realize that investing in tech funds was suicide at the time, yet these funds still carried the highest rankings from Morningstar. The fundamental problem is that three and five-year history is irrelevant.Besides the fact that the market shifts much faster than that, you also must keep in mind that fund managers often change. If your fund’s manager changed, what sense does it make to evaluate the track record of the person no longer at the helm? No much.

So how do you find the mutual funds with the best performance?

The first step for mutual fund evaluation is to look at the last twelve, nine, six and three-month performance. You can easily obtain this information if you look at Yahoo! or a variety of other sites. Or, if you have your money at TD Ameritrade or Fidelity, those custodians usually have user-friendly research centers that will help you obtain the same information. I suggest that you create your own small universe of the funds you like and continually update the trailing twelve, nine, six and three-month performance. You can average these four numbers, or you can weight the numbers depending on what period you want to emphasize. Then, you can invest in the top seven funds. This is a pretty simple process.

Of course, using this or any investment strategy won’t always lead to success. There will be times that you will underperform the market and there will be times when you outperform. There will be other times that you beat the market but still lose money. The nice thing about this is that you won’t be investing in funds that are far out of favor. That is the key. And as I said, this is even more important when it comes to tax-deferred accounts. You could have the best self-employed retirement plan or employer-provided plan but still lose a ton if you don’t select your investments carefully.

What strategy do you use when you invest? What have been the benefits and drawbacks?

 

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{ 3 comments… read them below or add one }

King Kovacs December 26, 2013 at 1:02 PM

Sorry, have to disagree on your comments of the value (gains vs. losses) of 3-year, 5-year, 10-year performance. The combined years of gains versus losses are vital in ascertaining the long-term success of mutual funds. Of course, an investor has to include the year-to-date performance to this analysis. Without this information, how else would the average investor know what mutual funds are successful and what mutual funds are not?

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Neal Frankle, CFP ® December 28, 2013 at 8:57 AM

King, Thanks. I guess we have to agree to disagree. If you look at the best 3 and 5 year performance in 2000, you’d pump your money into tech funds – and stay there for a very long and painful time. I personally prefer a more dynamic approach.

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King Kovacs December 28, 2013 at 10:38 AM

Neal, two points to consider. First, you’re right if an individual invested solely in technology before the bubble burst that would have been disastrous. However; if that same investor diversified into several different categories such as health, equity income, mid-cap growth, etc. the outcome of loss would have been significantly less. If you currently look at the multitude of investment categories in LargeDividends.com, you will see extremely favorable results for both for short and long-term performance.

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