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Exposing the myths in mutual funds

| MoneyRates.com Senior Financial Analyst, CFA
min read

To listen to mutual fund advertising, you would think that Wall Street is like Garrison Keillor's Lake Woebegone, where all the children are above average.

The reality, of course, is not nearly so idyllic. The S&P Persistence Scorecard -- a semiannual report on mutual fund performance over time -- lends some insight into why so many funds can claim to be top performers.

Lack of persistence

Mutual funds are frequently grouped into quartiles, with the top 25 percent being the top quartile, the next 25 percent the second quartile and so on. The S&P Persistence Scorecard measures the ability of mutual funds to repeat above-average performance from one year to the next.

By this standard, mutual funds suffer from a pronounced lack of persistence. According to the June 2014 issue of the Scorecard, only 3.78 percent of mutual funds were able to sustain top quartile performance over three consecutive one-year periods, and only 0.28 percent -- roughly one in every 400 mutual funds -- were able to do the trick for five consecutive periods.

Even when funds were held to a less lofty standard, few were able to exhibit persistently strong performance. Looking at top half rather than top quartile performance, only 18.66 percent were able to stay above average for three consecutive one-year periods, and just 4.47 percent stayed in the top half for five consecutive one-year periods.

If mutual funds cannot consistently repeat their performance, does that mean that choosing funds based on their track records is just a crapshoot? Those track records may be less meaningful than the ads suggest, but the S&P Persistence Scorecard helps explain what past performance does -- and doesn't -- mean.

What does it mean?

Here are some insights about performance measurement to be gleaned from the S&P Persistence Scorecard:

  1. Market conditions are rotational as well as cyclical. Besides up markets and down markets, styles and sectors of stocks move in and out of favor from year to year. Viewed from that perspective, the in-and-out performance of mutual funds is not so much disappointing as inevitable.
  2. Almost every dog has his day. The fact that funds seem to fall so quickly out of favor means other funds must be taking their place -- but they too quickly fall from grace. So, if a mutual fund has a great year, it really is not a big deal -- most get their time in the sun eventually.
  3. Performance measurement should be based on conditions, not calendars. The S&P Persistence Scorecard shows that besides being inconsistent from one single-year period to the next, funds have trouble repeating success over consecutive three- and five-year periods. That is because those periods don't necessarily measure a representative range of market conditions. After all, the past five years have been dominated by a strong market -- but wouldn't you also want to know how a fund did in the devastating bear market that preceded that? Measure performance over a period that includes one bull market and one bear market phase, and not according to some tidy calendar-based period.

Long-term investing is like the baseball season -- it is a long haul in which both good and bad teams are going to both win and lose a lot of games. Therefore, winning all the time should not be the standard. Winning more than your share and winning when it matters are what really distinguishes the champs from the chumps.

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