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Seek the Right Fund, Not the 'Best' Fund

Returns are just one tool for evaluation, not the be-all and end-all.

Eric Jacobson, 01/14/2010

With such extreme returns over the past couple of years it's worth reiterating some basic tenets of fund evaluation that can be overlooked when the market is zooming back and forth.

The Highest Return Does Not the Best Manager Make
During short time periods, some funds stand out with such remarkable gains that those returns alone appear to be proof positive of a manager's superior talent.

However, there are plenty of reasons such numbers don't guarantee superior management. The most obvious and important is that single periods are reflective of factors that may not be repeated the next time around. Many funds with outstanding 2009 returns could serve as an example. One of the clearest is the closed-end Eaton Vance New York Muni EVY, now appearing prominently on 2009 leaders' lists. This fund's NAV went up 62% in 2009 while its market price soared an incredible 94%. But the firm's own executives say those gains were largely the flip side of a harrowing 48% 2008 loss--one of its category's worst declines--that was in part due to the same portfolio leverage that fueled it in 2009. Therefore, only by evaluating the fund's performance over a much longer period of time could one reasonably evaluate its managers' true abilities. Just as important: Banking on this fund to again produce anything close to the kind of returns it earned in 2009 would be a mistake.

Longer Periods Can Prove Arbitrary and Thus Misleading
Is a single calendar year any more relevant to judging the skill of an investor than a period of a different length? Are one-, three-, and five-year trailing periods any more valid than those covering two-, four-, and six-year returns? The investment industry uses the first set of specific periods out of convention and convenience, and for the purposes of comparison they have some utility. But short periods can easily cause unusual distortions even in longer-term performance numbers; a fund's history of trailing returns can shoot up or crumble in the face of a severe short-term gain or loss. For this reason, looking only at a few select periods doesn't fully reflect the investor experience over time.

We see the effects of this problem every so often whenever the debate over indexing versus active management heats up. At any given time historical returns may confirm what everyone knows, which is that indexing beats active management--except during all those times when the opposite is proved.

The best assessment of a manager or strategy has to involve looking at multiple periods over time, sometimes slicing them up to better understand the effects of market moves, and to include as many as possible. Rolling returns are good for this purpose and provide insights unavailable in trailing or calendar-based periods. PAGEBREAK

Certainty Is Elusive
There's a clear desire for many of us to come to final conclusions that one fund or style is demonstrably and conclusively better than another. That's understandable, because that search is almost always undertaken when preparing to make an investment decision. For such an important task, it makes perfect sense to seek out conclusive proof that the decision you're about to make is the right one.

But while one can do a pretty good job of narrowing down a big universe of investment choices to a handful of good options--ideally sifting out most of the truly bad and many of the mediocre ones--identifying the "best" fund of any particular kind is a lot more difficult.

Aside from the time-period factors, there's a fundamental issue that in the mutual fund world, in particular, there's a surprising variety of differences when it comes to the actual investment mandates and parameters of funds. Even two with almost identical names in the same category may have quite different management styles. On the equity side, for example, we often see this most starkly among value funds. A fairly conventional one might define its approach primarily in terms of selecting stocks that are demonstrably cheaper by some measures than, say, the average name in the S&P 500. Another might be a much "deeper" value player, though, or even one that focuses on companies in distressed situations.

The differences among bond funds might be less obvious, but two otherwise conventional intermediate-term bond funds can have very similar mandates, use the same benchmark, and still differ meaningfully. One that pursues a so-called core-plus strategy (a tag common to the institutional market), for example, might do so by including as much as 15% or 25% in high-yield bonds. Another might do so by focusing a similarly sized bucket on high-quality, nondollar bonds. And yet others might reserve a bucket eligible for either and perhaps even throw in some emerging-markets debt.

One can reduce lists of funds down to a handful of demonstrably very good managers yet find it almost impossible to conclusively determine that one is objectively "better" than the others given the variations in their styles.

But the real question is why even try. Investing is about identifying options that help fulfill goals, not about finding that lone fund that is superior to all others. Splitting hairs in a quest for one be-all-and-end-all fund has diminishing returns and often can do more harm than good.

Eric Jacobson is a mutual fund analyst with Morningstar.

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