Using Past Performance to Choose Mutual Funds
Jan 12 2010
There is a simple solution to every complex problem. Unfortunately it never works. Case in point: using historical data to choose a mutual fund.
It certainly seems logical to use past returns to choose from the enormous number of mutual funds. Not only does it appear to be an apples-to-apples comparison but the winners are easy to identify.
And there is no shortage of data. In January there are typically dozens of articles on the “best performing” mutual funds for the previous year. Occasionally an article highlights “the best of the best” – funds that have outperformed their peers or the market as a whole for multi-year periods. Many times the articles go on to describe the fund manager’s strategy and the reasons behind his success.
All of this information should be taken with a large grain of salt. There are some very good reasons why regulators require mutual funds that advertise performance history to include the disclaimer: past performance does not guarantee future results.
The biggest reason to be skeptical is that in many cases a manager who appears to be a financial genius turns out to be someone who took a very big risk and got lucky. Last year was a particularly good year for risk-takers. Very risky asset classes such as “high yield bonds” (better known as “junk bonds”) and “emerging markets” returned two or three times as much as conservative investment like the S&P 500. Of course, in bad markets these risky investments can, and do, lose a lot more than the S&P 500. And while human nature tempts us to believe the opposite, it just isn’t possible to predict when a risk-taking fund manager’s lucky streak is going to begin or end.
Nor will historical data help you pick the next winners among more conservative fund managers. Study after study has shown historical returns to be an unreliable indicator of future superior performance (although poor performance tends to followed by more poor performance).
There are always exceptions to the rule. Bill Miller of Legg Mason Value Trust “beat the market” for an impressive fifteen years in a row (ending in 2005). The problem is that nowhere during that fifteen year period could you have been certain that his streak would continue. Nevertheless, the fund attracted enormous amounts of money on the strength of its relative performance only to lose an incredible 72% of its value in the eighteen months preceding the market low of last March.
Since then Miller’s fund has rebounded (although it hasn’t recovered all of its losses) and has recently been included on lists of funds that “beat the market in 2009.” Investors who buy the fund on the strength of last year’s performance don’t realize that their decision is based more on luck than skill.
