The Remarkable Gap Between Winners and Losers

Too often, people assume that one fund is as good as the next. Or they put in the effort to pick their stock funds but buy their bond funds from whichever fund company is most convenient. But that's leaving a lot of money on the table. As the immortal Spinal Tap lead singer David St. Hubbins said, "It's such a fine line between stupid and clever." Put a little time into your fund selection, and you'll be on the right side of the St. Hubbins line.

It's amazing to me how people will spend way more time researching fun expenditures, like cars and plasma 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!

Let's look at why it's worth a little effort. It's not too hard to pick funds that will do a little better than average, and it takes only a little more work to upgrade from there so that you've meaningfully improved your chances of returns that are well above average while reducing your chances of lousy performance. Of course, there's no foolproof method of predicting the top-performing fund over the next 10 years, but there are dependable methods to select funds that should earn strong returns while limiting cellar-dwellers.

The Forest for the Trees
Sometimes short-term returns, such as those for a six-month period, can be all bunched together. From that perspective, funds in a particular category might all look alike. If you step back and look at the effects of long-term compounding, however, the differences get dramatic. You can see the gaps in figure below, where even among low-returning bond funds the gap is quite wide.

Let's consider the returns of large-blend funds returns over the past 10 years. The large-blend category, which is home to a passel of S&P 500 Index funds, 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: Funds in the top quartile gained 7.02% per year over the 10-year period; funds in the second quartile rose 4.06% per year; the third, 3.23%; and the fourth, 2.9%. That's a huge gap from the top quartile to the second and down to the fourth.

In honor of St. Hubbins, let's call the gap between the top and bottom quartiles 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 in the typical top-quartile large-blend fund 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 the foreign large-blend group, the top quartile returned 9.16% compared with 6.49%, 5.38%, and 3.24% for the three other quartiles, respectively. For the intermediate-bond fund category, returns were 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 the risk spectrum and found not much changed in the gaps. For short-term bond funds, the breakdown was 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 the diversified emerging-markets stock category, returns were 16.62%, 13.31%, 11.58%, and 9.84%.

One of the most striking aspects of the study is that it even works across categories. Except for the emerging-markets stock fund category, 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-quartile or even second-best-quartile large-blend fund. The top quartile of intermediate-bond funds beat the bottom-half returns for the foreign large-blend group.

Improve Your Chances of Success
In short, you'll make it much easier to beat your investment goals if you can select outperformers. No, you won't bat 1.000, but you should be able to be on the right side of the St. Hubbins line most of the time.

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

The returns we just reviewed include only funds that were good enough to survive in the first place. It's tough to take into account those funds that were around for only part of the time period. 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.

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