The Truth About One-Year Returns

Stock funds are having a great year. Now, the question is: What should you do with that information?

It’s hard not to notice when a fund makes large gains in a short amount of time. But just in case you missed it, some fund shops will no doubt crank out ads touting big 12-month or year-to-date returns. See Gregg Wolper's recent Fund Spy for more on the first performance ads of the season.

That said, a fund's 12-month return does contain some very useful information--provided you view it within the context of the fund’s strategy and long-term returns. For example, lately I’ve been watching recent returns of growth funds closely because it’s been so long since there was a growth rally. Many funds have overhauled their strategy or their portfolio--or both--during the three-year bear market, and recent returns during the latest market jump can indicate which ones are more cautious now and which are still bold. With bond funds, even shorter periods of time are telling. Because rates spiked in July, a fund’s July performance is a very good gauge for how much interest-rate risk it courts.

However, it's important to take short term returns with a grain of salt. For example, don't look at a big number and decide it means the fund will continue to produce big returns and that the manager is brilliant. In fact, it doesn’t tell you either of those things. If a fund has really extreme year-to-date or calendar-year returns, it’s much more likely to hit the skids than continue soaring.

For proof, let's take a look at what has happened to the 10 highest-returning funds of 1999. During that year, the top performers put up gains that I would never have guessed possible in a mutual fund, soaring between 237% and 314%. Most had decent managers, but they were focused on a narrow range of vastly overpriced stocks--and they soon paid the price for it. Had you used the top-10 performers' table as your shopping list, the best you could have done from January 1, 2000 through March, 2003 was lose a little more than half your money. The worst you could have fared was a 91% loss in the now-extinct Van Wagoner Post-Venture Capital Fund.

How could this have happened at funds that were competently managed? Simple. Their holdings were overpriced, and there wasn’t a lot that could be done. Conversely, what might look like incompetence at one point can look very different when the tables are turned: The 10 worst-performing funds from 1999 would have given you decent returns during the bear market, as only two lost money.

To be sure, the downside won’t normally be as extreme as the subsequent collapse suffered by those top funds from 1999, but in general you’re making a bad bet when you buy based on attractive short-term returns. Indeed, even if you exclude the first year of the meltdown, things weren’t much better for those fallen stars of the bubble. Nine of 1999's 10 top performers suffered double-digit losses from January 2001 through March 2003, while one gained less than 1%.

Poll Results
In last week's voting among interdisciplinary poll leaders, the University of Oklahoma football team and NBA draftee LeBron James each received more votes than any of the top Manager of the Year candidates. Among the fund managers, domestic-stock standout Bill Fries of Thornburg Value was the leader with 22% of the vote, nearly as much as LeBron James.