Five Factors that Trump Short-Term Returns

Picture this. It's Sept. 7, and you're watching the first game of the NFL season. The Miami Dolphins take the opening kickoff from Pittsburgh, drive down the field, and score a touchdown. A friend turns to you and says, "The Steelers stink. Why would anyone pick them to win the Super Bowl?"

You would understandably conclude that your friend doesn't know anything about football, right? The game's only five minutes old, so how could one possibly draw conclusions about the outcome of the game, let alone the whole season?

Yet I get the investing equivalent of those comments every single day. Stock investments are for the long haul, and you can't judge stock funds by six months' worth of performance when they're designed to get you to your goals 15 years down the road. But every day I hear about how a fund is great because it had a good year-to-date return or maybe a couple of good years. I also hear complaints about how we have recommended investments that had a bad year or two. In my 11 years at Morningstar, I've found that this sort of short-termism is far and away the most common mistake investors make. Short-termers chased emerging markets in 1993, and it took nearly 10 years for emerging markets to come back. We've also had a couple of biotech bubbles, a blue-chip stock bubble, and, of course, an Internet bubble, and I've seen investors shoot themselves in the foot each time.

When the Internet bubble burst and short-termers were down 70% while savvy diversified investors were down 20% or so, I thought that might cure investors of chasing performance. And for a while they were cured. I heard much more interest in the management behind the fund and corporate culture and strategy, too. Except for a few hard-core performance-chasers who thought bear market funds would go up, up, up, the hot-fund buzz pretty much died away.

But now that the bear market is three years back in our rearview mirrors, novice investors are back to making some similar mistakes, chasing commodities, energy, and, yes, emerging markets. Most fund companies have gotten religion about not encouraging short-term performance-chasing, but not all have.

Better to learn the lesson in a column than in your life savings, so I'll say it here: Short-term performance is mostly noise, and recent return figures provide very little guidance about what will work for the next 10 years.

I ran a quick screen for the five diversified funds with the best 15-year returns. Each returned better than 17% annualized over that stretch, meaning a $100,000 investment back in 1991 would be worth $1 million today. Yet each fund had bouts of poor performance along the way. And we're not talking about a single off year neatly placed with seven great years on either side. All five underperformed their peer group in at least five of the past 15 calendar years--one even lagged in seven out of 15. All had at least one year of losses, and three had at least three years in the red.

With that in mind, here are five factors (listed alphabetically) that matter more than short-term performance if you're trying to predict long-term success. In fact, each issue of Morningstar FundInvestor explains why a fund is an Analyst Pick by walking through five key fundamental factors--four are part of the list below. (The fifth is strategy.) We're always working to test factors for predictive value, so I could name 10 that are more valuable than short-term returns, but this is a start.

Costs
Expense ratios have proved to be as good a predictor of future performance as any. The reason is that expense ratios are a constant factor in fund returns and are pretty stable. That means that through dramatic shifts in the economy, markets, and even changes in fund management, low-cost funds are going to compound at a greater rate for their shareholders and high-cost funds are going to erode returns at a greater rate. Moreover, the managers at low-cost funds are often better paid than those at high-cost funds, so you're getting better management. That may sound counterintuitive, but it makes sense when you think in dollar terms. Good managers are likely to run larger funds, so a fee of 50 basis points on a $10 billion fund means more money in that manager's pocket than another manager who earns 100 basis points on a $100 million fund. As Jack Bogle likes to say, you get what you don't pay for.

Long-Term Relative Performance
While short-term performance is noise, there really is valuable information in long-term performance. Yes, there's still noise in there, but managers with strong long-term records of outperforming their peers are a pretty good bet.

Management
The manager and analysts running a fund have an enormous impact on a fund's success. The fund industry is a little funny in that you have very skilled and seasoned managers supported by brilliant analysts listed right alongside dudes running a fund out of their garage. Soon after I started at Morningstar, one manager we called couldn't come to the phone because he was mowing his lawn. The relatively low barriers to entry in the fund industry make for a wonderful meritocracy in which everyone has to prove their mettle, but that level playing field also makes it vital that you distinguish between the skilled top managers and their less talented brethren.

Stewardship
Our Stewardship Grades capture a host of crucial factors that gauge how dedicated a fund company is to its investors. These factors have very real impacts on a fund's returns. If a manager is purely focused on his bottom line, he and his analysts are more likely to bolt the fund at first sign of a higher bidder for their services. Likewise, a fund company that's too focused on the next quarter is more likely to mark up fees on a variety of services as well as keep the fund open long past the optimal asset size.

Suitability
This isn't a data point: It's about knowing what you need. It's what a good financial planner will help you to figure out. Even if you don't have one, though, you'll find investing is much easier when you begin by thinking about what your goals and needs are before you head for the performance tables. Consider what your investment time horizon is and what your tax situation over that time will be. Say you are investing for your retirement in 20 years and you expect to be in the highest tax bracket. Then a low-turnover stock fund is most likely to fit the bill, and please pick one you can hold on to for all of those years or at least most of them. Conversely, if you're in a low tax bracket and you're saving for a house or car in two years, a taxable-bond fund might be what you need. Viewed in the context of your goals, it should be much easier to choose the right fund.

Etc.
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