Picking the Right Funds Makes a Huge Difference

It's such a fine line between stupid, and clever.--David St. Hubbins

It's amazing to me how people will spend way more time researching fun expenditures like cars and flat-screen TVs than they will on developing an investment plan and selecting their investments. Sure, it isn't as fun, but it's your retirement, your house, and your kids' college education!

It's not too hard to pick funds that will at least outperform their peers over the long haul, and it only takes a little more work to upgrade from there so that you've meaningfully improved your chances of excellent performance while reducing your chances of lousy performance. Not to suggest that there's a foolproof method guaranteeing top-quartile returns, but there are very dependable methods to get mostly above-average results and limit cellar-dwellers.

The Forest for the Trees
When you look at short-term results like year-to-date returns, it's easy to think that most funds are alike, but when you step back and look at the effects of long-term compounding, the differences get dramatic.

Let's consider the past 10 years of large-blend fund returns. It's a group that might seem like a bunch of bland benchmark-huggers. But consider the differences in average 10-year annualized returns for each quartile through April 2008: top: 7.02%, second: 4.06%, third: 3.23%, and fourth: 2.9%. That's a huge gap from the top quartile to the second and down to the fourth. In honor of musical genius David St. Hubbins, let's call the gap between the top and bottom quartiles the clever premium or maybe the stupid penalty. In the case of large-blend funds, it's more than 400 basis points. Put in dollar terms, $100,000 invested 10 years ago grew to $197,000 today versus $149,000 for the second quartile and $133,000 for the worst--making a stupid penalty of $64,000!

The gap remains dramatic in other categories. For foreign large-blend, it goes 9.16%, 6.49%, 5.38%, and 3.24%. For intermediate bond, it's 6.02%, 5.25%, 4.85%, and 4.07%--that's a big gap for high-quality bond funds. Then, I checked two categories at the extreme ends of risk and found not much changed in the gaps. For short-term bonds, the breakdown goes 4.93%, 4.47%, 4.10%, and 3.91%. It's amazing to think that you can do 100 basis points better per year in a category where yields and returns are so tightly bunched. For red-hot diversified emerging markets, it's 16.62%, 13.31%, 11.58%, and 9.84%.

One of the most striking aspects to this data is that it even works across categories. Except for emerging markets, you could take the top quartile of one of the four other categories and beat the bottom quartile of other groups. For example, you'd have been better off in a top-quartile short-term bond fund than a bottom or even second-best quartile in large blend. The top quartile of intermediate bonds beat the bottom-half returns for foreign large-blend.

Improve Your Chances of Success
In short, you'll make it much easier to beat your goals if you can select outperformers. You can read about how we go about building our  Fund Analyst Picks list here to get a more complete idea, but simply choosing low-cost funds will get you a long way to the answer.

Don't settle for high-cost, poorly run funds simply because they fell into your portfolio. Take the time to research and buy funds that will work for the long haul. Three months from now you won't see a difference, but you will in 10 and 20 years when the power of compounding has grown your portfolio.

Survivorship Bias Note
The returns I mentioned reflect still-active funds because it's mighty tough to take into account funds around for only part of the time period. However, suffice it to say that if we could factor those in, the gap would be even greater. The crummiest funds are the ones generally killed off, so the bottom-quartile figures would be even worse if extinct funds could be included.