Wise Choices Seldom on ‘Top’ or ‘Bottom’ List

Now’s the time of year when newspapers and magazines around the country publish annual performance reports for individual mutual funds.

Such numbers make it easy for investors to check on their holdings long before they receive any performance notice themselves, but they also can cause anxiety and second-guessing among shareholders who can’t understand why their picks didn’t finish at the top of the previous year’s rankings.

The grass always seems greener in the other guy’s portfolio.

For people who wonder if their holdings fared well enough--and whether they should consider making adjustments--it’s important to keep the performance results in the proper perspective. The following observations can help:

* Risk and return usually go hand in hand, which means managers in top-performing funds likely had to place big bets to get where they are.

In 1994, 11 of the 25 top gainers were sector funds--portfolios that concentrate their holdings in a single industry. Three others were volatile single-country or regional foreign funds. Sector, single-country and regional funds made up more than half of the 25 biggest losers last year.

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By contrast, the stodgy balanced, equity-income and asset-allocation funds didn’t show up in either the top 25 or bottom 25 for 1994. These funds rarely show extreme performance numbers.

* Ranking well against similar portfolios and market indexes is more relevant than finishing among the top names.

“There’s no way to be in the No. 1 fund on a consistent basis,” says Stephen L. McKee, president of the No-Load Mutual Fund Selections & Timing Newsletter in Richardson, Tex. He strives to keep investors in funds that rank within the top quintile--that is, in the top 20% of their categories.

The Value Line Mutual Fund Survey divides each fund’s yearly returns in “quintiles.” The rival Morningstar Mutual Funds ranks funds in “quartiles,” or quarters. Both research publications can be found in many libraries.

* Large funds rarely rank among the best or worst performers for the year. The big portfolios typically spread shareholder assets among hundreds of stocks. Such diversification tends to keep their returns closer in line with the broad market--at least in comparison with smaller funds that can take big bets on a handful of stocks.

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This factor alone will probably keep you from enjoying bragging rights to a “Top 25” fund. Nearly two-thirds of all stock-fund assets are concentrated in about 150 big portfolios, each counting $1 billion or more. Yet billion-dollar funds rarely finish in the top 25.

In short, it can be frustrating--if not dangerous--to chase after last year’s biggest-gains funds, and most financial advisers would recommend against the practice.

“Don’t chase last year’s rainbows, because they’re likely to disappear by the time you get in,” says Laura Lee Wagner, a certified financial planner at American Express Financial Advisors in Phoenix.

But this doesn’t answer the related question of how long you should hold onto a fund that’s lagging, and on this point there’s no consensus.

Wagner says she can tolerate a poor record for one year if the fund’s numbers over the last three, five and 10 years look good.

Robert Berlinger of Westmount Asset Management in Los Angeles says he considers selling after six to 12 months of poor performance in comparison to funds of similar kind and an appropriate market index, especially if the fund manager appears to be taking on extra risk.

And Sheldon Jacobs of The No-Load Fund Investor newsletter in Irvington-on-Hudson, N.Y., says he might sell unless the fund’s performance mostly remains in the best or second-best “quintiles” for its peer group, based on several time frames ranging from a month to five years.

Evaluating performance, perhaps more than any other factor, makes fund selection an art rather than a science.

And just to complicate matters, there has been increasing talk lately that past performance really doesn’t always count for much as a tool of prediction.

A recent example: CGM Capital Development had the second-best track record of any mutual fund over both the 10-year and 15-year periods ending Dec. 31, 1993. Last March, Money magazine cited it as one of “8 Investments That Never Lose Money.”

So what happens? CGM Capital Development stumbles badly in 1994, falling 23% for the year and winding up on the bottom-25 list compiled by Lipper Analytical Services of Summit, N.J. Critics say that individual-fund performance in general is simply unpredictable.

Still, it’s not likely that people will stop looking at past investment results.

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“Investors seeking instant gratification will find (past performance) a mercurial guide,” said Don Phillips, publisher of Morningstar Mutual Funds in Chicago. “Still, it’s the best guide we have.”

The moral of the story is that investors should be careful about chasing after funds on the basis of performance numbers alone.

Make sure a fund also exhibits reasonably low expenses, managerial consistency and a focused investment approach. In addition, make sure the fund company offers the shareholder services you want and that the investment fits nicely in your overall portfolio, that it complements your other holdings.

Above all, make sure you can tolerate likely price swings, because a big part of investing is staying in the contest long enough for hoped-for gains to materialize.