Don’t get suckered: Last year’s fund winners often go bad

January 12, 2016

NEW YORK (AP) — It’s tempting to look at which mutual funds did best in 2015 and just invest in those. Winners win, right?

Not in the investing world. It’s tough for funds to stay on top, and last year’s winners regularly turn into this year’s losers.

Look at what happened to the handful of index and actively managed mutual funds that returned 40 percent or more in 2014. Their returns towered over the 14 percent that a Standard & Poor’s 500 index fund produced.

But seven of the 10 went on to lose money the following year. You would have had a slightly better chance of making money in 2015 by picking a fund at random.
The figures dovetail with a raft of studies that suggest investors should consider much more than just past performance when choosing funds.

It turns out that even when funds perform well over long periods, compared with similar funds, it doesn’t mean they will continue to do so.

A study released by Morningstar this week looked at fund returns in 14 categories, going back to 1996. It identified which high-yield bond funds were in the top 20 percent for the five years through 2001, then checked to see how they performed over the ensuing five years against the funds that had been in the bottom 20 percent.

The researchers found only small differences in ensuing success for the top and bottom funds in most categories, as long as the time frame was longer than a year.

“Even the best managers generally do not consistently outperform,” the researchers wrote in their report. “Those who lack the patience to stick with an active manager through multiyear rough patches may be better off in a low-cost index fund.”

S&P Dow Jones Indices, meanwhile, keeps its own scorecard of how many mutual-fund managers are able to stay in the top quartile or even top half of their categories. Its verdict: very few.

Of the 539 funds that ranked in the top half of large-company funds in the year through March 2011, 52 percent repeated the feat the following year. That’s only slightly better than a coin flip.

How many of those 539 funds were able to remain in the top half for five consecutive years? Less than 5 percent.

The difficulty fund managers have in staying on top serves as a reminder to resist the temptation to hop from one fad to another. Investors are notorious for chasing after whatever’s performing well and fleeing whatever’s struggling.

In other words, they often buy high and sell low, and it’s why investors often have worse returns than the funds they invest in do.

The largest actively managed stock fund, American Funds’ Growth Fund of America, returned an annualized 7.2 percent over the decade through 2015, for example.

That’s how much investors would have made if they bought at the start of that decade and then simply held it. But most investors didn’t do that. Instead, many bought more shares when performance was good and sold when performance lagged. That means the average investor in the fund got a 5.3 percent annual return over the decade, according to Morningstar.

Investors should also look to keep their fund expenses low. A fund with high fees has to perform much better just to match the performance of a low-fee fund.

The good news is that investors seem to be doing just that. Dollars have been flowing into the funds with the lowest expenses for years. Index funds, which have lower costs because they try to simply match the market’s performance rather than beat it, have been getting many of those dollars.