Why High Mutual Fund Returns can be Deceiving

Do Historical Results Really Matter?

Why High Mutual Fund Returns can be Deceiving
January 7, 2015

Before purchasing shares in a mutual fund, the first thing many people do is look at the historical performance of the fund. After all, if a mutual fund delivered high returns in the recent past, this is a good indication that it will probably perform well in the future, right?

Well, it appears this is not necessarily the case. The data indicates that strong past performance by a mutual fund does not always correlate to strong future performance. In one study that examined 16 years’ worth of performance data on mutual funds, only 8 percent of the top 100 fund managers in a given year were top managers again the next year.

Volatility and Unpredictability

As it turns out, there is a very good reason that mutual fund prospectuses always include the disclaimer: “Past performance is no guarantee of future results.” But why is this the case?

One reason is the simple fact that the stock market is inherently volatile and unpredictable. Regardless of how good a fund manager might be, he or she will inevitably experience down years when performance lags behind market indices. Another study found that many fund managers who outperformed over a 10-year period still experienced short-term periods where they trailed their market indices.

Another reason is that funds that have performed well in the recent past may have risen too far, too fast. For example, let’s say a mutual fund’s share price rose from $40 to $50 over the past year, a healthy 25 percent return. After such a rapid rise, though, it would not be unusual for the fund to come back down to earth a little bit, which could lead to a loss during the year following this rapid rise.

A Better Approach

Instead of looking back at past performance, it is usually better to try to look ahead toward potential future performance. Doing so requires a little more work and due diligence than just reviewing a fund’s past performance statistics.

Start by researching the fund’s investment manager. How long has he or she been managing the fund? What was the manager’s track record at other funds before managing this one? How much expertise and experience does the manager have in this particular sector and asset class? What is the manager’s overall investment strategy?

Another thing to look at carefully is a mutual fund’s fee structure and expense ratios. In general, the lower the fees, the stronger a fund’s future performance may be. This is one reason why index mutual funds, which track the performance of a particular market index (like the S&P 500, for example) are so popular. These funds typically feature much lower fees than actively managed funds that are run by highly paid managers. In fact, 68 percent of large-cap value funds actually trailed their benchmark index over the past five years, according to Vanguard.

Don’t Forget the Prospectus

Also, study a mutual fund’s prospectus very carefully before purchasing shares. The prospectus is chocked full of meaty information that can help you determine how the fund might perform in the future. In particular, perform more research on the companies that constitute the fund’s top holdings to get a better feel for these companies’ prospects over the short, medium and long term.

Before purchasing shares in a mutual fund, take the time to look ahead to try to gauge how the fund might perform in the future, rather than just looking behind at how the fund performed in the past. Historical results generally are not the best predictor of how mutual funds might perform in the future.

Photo ©iStockphoto.com/meshaphoto

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