Topnotch Funds That Investors Have Used Well
Investor returns have outpaced total returns for a handful of analyst favorites.
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Here's a little experiment that can help you figure out what kind of investor you are. Let's say you're talking with two friends one day and the subject turns to mutual funds. One friend brags about how a fund he owns has been delivering stellar, market-beating returns for years and invites you to get on board the gravy train. The second friend, looking sullen, gripes about how his fund has been a lackluster performer ever since he bought it and urges you to steer clear. To which friend's comments do you pay more attention?
If you're like most people, you'd probably focus on what the first friend says. It's only human nature to want in on a good thing, especially if it might fatten your wallet. But you might actually be better-served listening to friend number two. That's because today's high-flying fund often turns out to be tomorrow's laggard, while today's laggard often (though not always) improves its performance. Jeff Ptak, president and chief investment officer of Morningstar Investment Services, explored this phenomenon in the June/July issue of Morningstar Advisor magazine; subscription required. Using rolling five-year returns he found that funds in a category's top quartile one year almost always fall out of it within a few years, while funds in a category's bottom half are more likely than those in its top half to rise to the top quartile five years later.
Following friend number one into the hot fund would be a classic case of performance-chasing, an all-too-common phenomenon in the investing world in which more successful stocks, funds, and other investment types attract new assets as more investors want in on the action. Unfortunately this herd of new investors typically gets in at the wrong time--when the investment is nearing the end of its bull run and due for a fall.
Investor-return data for mutual funds bear this out. If you click on the Performance tab on any individual mutual fund page on Morningstar.com, you'll see a link to Investor Returns near the top. Click it and you'll see how the fund performed for investors on average versus how the fund performed overall. Why aren't these two numbers the same? Because investors are constantly adding or withdrawing assets to funds, and the investor-return statistic factors in these fund flows to show what the average investor actually experienced as opposed to the total return, which shows what an investor who simply bought the fund and held on throughout the time period would have experienced. So if investors plowed money into a fund just before it took a nosedive, then bailed before the fund rebounded (as happens all too often), the fund's investor returns will look lousy relative to its total return. (You can read more about Morningstar's Investor Return methodology here.)
Fortunately, this isn't always the case. Investors do use some funds better than others, which is another way of saying investor returns for some funds beat the funds' total returns. In fact, out of 1,383 equity and taxable-bond funds with at least 10 years' worth of investor-return data in Morningstar's database, about one fifth had investor returns that beat the funds' total returns on an annualized basis during the past decade (as of June 30). Funds that investors used well came from a wide range of categories, but in many cases investor returns surpassed total returns during the trailing 10-year time period but lagged during the trailing five-year period. This could be an indication that at least some of the funds' shareholders were spooked by the late 2008 market drop and sold their stakes, thus missing out when the market began to rebound the following March. (Some investors also may have remained in equities but switched to exchange-traded funds, which have increased in popularity during that time.)
Below are some examples of funds that investors used wisely during both the trailing five-year and trailing 10-year periods and that have Morningstar Analyst Ratings of Gold or Silver. One common theme you'll notice: Investors tend to use funds with low Morningstar Risk ratings well. These low ratings show that the funds have experienced less downside volatility than their peers. Lower downside volatility often means shareholders are less likely to jump ship in choppy waters.
Small Growth
Conestoga Small Cap (CCASX)
Despite an upcoming management change here, Morningstar fund analyst Janet Yang says shareholders will remain in good hands. The fund's experienced team looks for small companies with solid franchises and a return on equity of at least 15%, and they tend to hold on to their picks for three to four years. The fund has outperformed during down markets but might lag during upswings. The fund's 27% loss in 2008 was 14 points better than the category average. It sports a Morningstar Risk rating of low.
Foreign Large Value
MFS International Value (MGIAX)
This fund's management team focuses on high-quality firms with sustainable competitive edges trading at attractive prices. Its country and sector weightings tend to be distinctive, and its managers are unafraid to venture into mid-cap territory if they see opportunities. The fund has performed particularly well in down markets--in 2011 it lost just 2% while the average foreign large-value fund lost 13%. Morningstar analyst William Rocco says the fund makes an excellent core foreign holding for the long haul. The fund may charge a load.
Large Blend
BBH Core Select
The approach used by fund managers Tim Hartch and Mike Keller--targeting high-quality, highly liquid large-cap stocks--along with top-decile performances in 2011 and 2012, have expanded the fund's asset base from $893 million at the end of 2011 to $5.1 billion as of June 2013. As a result, the fund is now closed to new investors. In fact, closing a fund can help its investor return because it stops the flow of money coming from performance chasers. The fund's low-risk/high-reward profile (it carries a Morningstar Risk rating of low) has surely contributed to investors staying the course here. A no-load version of the fund (also closed) carries an expense ratio of 1.25%.
Mid-Blend
FMI Common Stock (FMIMX)
The management team of another fund that has experienced less volatility than its peers, FMI Common Stock, seeks strong, durable businesses trading at reasonable valuations and plans to hold on to a stock for four years. This fund, too, is currently closed to new investors. Although its performance in recent years has been spotty, its five- and 10-year trailing returns land in the top decile of its category.
Moderate Allocation
FPA Crescent (FPACX)
Investors tend to use allocation funds, which hold a substantial portion of assets in stocks and bonds (and which were formerly called Balanced funds), rather well, most likely because of their lower volatility profile compared with pure equity funds. Morningstar analyst Dan Culloton describes this fund's manager, Steve Romick, as "an omnivorous contrarian who has demonstrated during two decades that he can sniff out value among stocks of all sizes and bonds of varying credit quality." The fund attempts to deliver equitylike returns with less volatility than that of the stock market. Its Morningstar Risk rating might only be average (compared with its moderate-allocation peers), but it has outperformed the group by an average of 1.8 and 2.6 percentage points per year during the trailing five- and 10-year periods, respectively (as of July 18). However, expenses are above-average for a no-load, moderate-allocation fund.
For a broader look at investor-return data by category group, read Morningstar director of fund research Russ Kinnel's "Mind the Gap 2011" article and also take a look at this article from last year.
Data as of July 18.