Personal Finance: Mutual funds–telling the hot from the not
In virtually every aspect of our consumer lives, we seek out the biggest bargains, with one exception—mutual funds.
When it comes to funds, investors tend to do the opposite: Favor those shares whose prices have already risen, while shunning those trading at low, low prices. Indeed, academic research shows that the vast majority of new investment dollars go to funds that have already garnered top ratings from Morningstar, whose ratings are based in large part on past performance.
Yet a new study by Standard & Poor's, released this week, reinforces the danger of chasing hot funds. S&P found that only around 1 in 10 funds managed to finish among the top 25 percent of its peers for three consecutive 12-month periods, through May 31, 2005. In other words, funds that make it to the top ranks have a hard time repeating.
In fact, funds have a difficult time simply being average on a consistent basis. S&P also went back and studied the performance of blue-chip funds over the past five years, and found that only around 1 in 7 large-cap stock funds managed to finish in the top half of its peer group for each of those years.
For fund investors, this sounds depressing. But there is some news you can use in S&P's study. For instance, those portfolios that managed to repeat as better-than-average performers over the past five years shared some interesting traits:
- Their managers tended to be more experienced. Among better-than-average large-cap stock funds, the average tenure was 9.3 years (in other words, the same manager has run the fund for nearly a decade). That's three years more than the average six-year tenure of all large-cap managers. So all things being equal, seek out funds with experienced and stable management.
- Better-than-average funds were cheaper than average. The average expense ratio of winning blue-chip funds was 0.98 percent of assets. By comparison, the overall expense ratio for all large-cap funds is 1.14 percent. The more a fund charges, the better it has to be just to be average. That's because a fund's expense ratio comes straight out of total returns. So a fund that generates 3 percent in market returns but charges 2 percent in fees actually earns its shareholders only 1 percent in total returns. The bottom line: Stick with low-fee funds.
- They lost less than their peers during the recent bear market. The average blue-chip fund that has consistently beaten its peers lost nearly 23 percent during the bear market. By comparison, blue-chip funds in general lost nearly 37 percent during this stretch. This means better-than-average funds don't necessarily shoot out the lights but rather minimize losses during downturns. The lesson: Stick with the tortoises over the hares.