One of the toughest questions confronting investors is whether to buy mutual funds based on their long- or short-term track records. It's a question that seems to pop up every quarter, when fund performance results are publicized.
Although few advisers would have you chasing after something so ephemeral as a top three- or six-month performer, there's plenty of disagreement over time spans of one year or more.
Some pros feel that since lengthier results cover more investment climates, they're more reliable. But others say shorter returns are more indicative of how a fund will fare in the immediate future.
The debate over performance periods isn't helped by the fact that several studies have tackled this question, with conflicting results. Here's a sample of what's been examined:
The Pioneer Group of Boston looked at the simple strategy of buying the top-performing mutual fund each year and holding it for 12 months--until a new winner emerged. For example, the top fund of 1972, Templeton Growth, would have been bought on Jan. 1, 1973, and held until the following New Year's Day, when that fund was dropped in favor of the 1973 champion, International Investors.
This simple switch-to-the-winner approach generated a respectable 11.9% annual compounded return from 1973 through 1992, assuming all dividends and capital gains were reinvested and all loads and redemption charges deducted.
It would have beaten the unmanaged Standard & Poor's 500 index by about half a percent annually. Compared to an S&P; 500 index fund, with modest operating expenses factored in, the margin would have been closer to a full point.
But the risks of such a strategy would have been considerable, says David Tripple, Pioneer's chief investment officer. On four occasions from 1973 through 1992, the reigning champion fell more than 20% the following year.
His conclusion: Buying the hottest funds on the basis of their one-year returns can be dangerous.
A similar type of study was conducted by John C. Bogle, chairman of the Vanguard Group in Valley Forge, Pa. But instead of tracking just the top fund in a particular year, Bogle looked at a changing mix of 20 superior portfolios--the honored few selected to Forbes magazine's annual honor roll. These funds get chosen on the basis of superior returns over various time frames, including both up and down markets.
Bogle assumed that an investor would hold an equal amount in each of the 20 funds, dropping those that fell off the list and purchasing their replacements. Including reinvestments, sales charges and other fund expenses, this strategy would have returned 11.2% compounded annually from 1974 through 1992, the 19-year period studied. That compares with 12.9% a year for the unmanaged S&P; 500.
Bogle concluded that picking superior funds is plenty hard because past performance isn't a good predictor of the future. He instead urged investors to consider index funds for at least a portion of their holdings, since these portfolios can be expected to track the market pretty closely and at low cost.
But a 1992 study by Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Hastings-on-Hudson, N.Y., reached a different conclusion. Jacobs determined that purchasing each year's top-ranked fund at the beginning of the following year would generate superior returns--certainly better than buying those portfolios with the best five- or 10-year records.
Jacobs limited his study to widely diversified equity funds and to no-loads, those that charge no initial fees. The fact that sales charges didn't erode any of the gains may explain why he came to a different conclusion from those reached in the Pioneer and Vanguard studies.
The Wall Street Journal in a 1992 study also determined that buying hot funds on the basis of their one-year records isn't such a bad idea. The Journal made an intriguing if impractical assumption that three investors would each buy the top 25% of all diversified stock funds (load as well as no-load).
One person would make his or her purchases based on best one-year performance, while the other two focused on five-year and 10-year records. This study then assumed that the three investors would hang on to their funds for five years. Results from 19 separate or rolling five-year time frames were analyzed.
The study found that a portfolio of top one-year funds would have achieved a blistering 14.4% annual compounded return, compared with 12.6% for funds with the best five-year records and 12.8% for those with superior 10-year performance.
Why would funds with superior one-year track records do the best? The Journal suggested that it had to do with investment cycles involving small, large, growth and value stocks.
These trends often last for several years at a stretch, so buying a top fund relatively early in its cycle--after one year--positions an investor for further gains, the theory goes.
Jacobs adds two further explanations favoring one-year performance:
First, funds that have done extremely well for five or 10 years are likely to have grown to a huge size, which tends to restrict performance. Second, the older a fund gets, the more likely there will have been a management change.
It's worth noting that Jacobs describes an investment strategy centered around one-year results as a "high-risk approach." The problem is that top funds tend to be fairly volatile, and they could fall sharply in a bear market.
"For your core investments, we still believe that the optimum performance results will be obtained from funds which have been good performers in both the short and long term," he says.
Buying the Best
A strategy of purchasing each year's top-performing mutual fund at the start of the following year would have delivered decent through highly volatile returns, according to a study by the Pioneer Group. Here's a look at the top funds of the past 20 years and how they fared in the subsequent year.
Following year's Top fund Year Return return Templeton Growth 1972 +68.6% -9.8% International Investors 1973 +91.9 +11.0 Sherman Dean 1974 +24.8 +20.4 44 Wall Street 1975 +184.1 +46.5 Sequoia 1976 +72.5 +19.9 Value Line Leveraged Growth 1977 +51.5 +27.6 Merrill Lynch Pacific 1978 +58.9 -23.4 Strategic Investments 1979 +194.6 +74.2 Hartwell Emerging Growth 1980 +93.9 -13.2 Oppenheimer Target 1981 +48.2 +81.3 Oppenheimer Target 1982 +81.3 +24.5 Oppenheimer Regency 1983 +58.1 -23.2 Prudential Bache Utility 1984 +38.6 +33.3 Fidelity Overseas 1985 +78.7 +69.2 Merrill Lynch Pacific 1986 +77.8 +10.7 Oppenheimer 90-10 1987 +93.5 -5.0 Columbia Special 1988 +42.5 +31.9 United Services Gold Shares 1989 +64.7 -34.2 Fidelity Select Biotechnology 1990 +44.3 +99.0 Oppenheimer Global Bio-Tech 1991 +121.1 -22.9
Source: CDA/Wiesenberger of Rockville, Md.