- Low Expense Ratios
- High Tax Efficiency
- Consistently Good Performance Year-to-Year Relative to Similar Funds
- Low Category Risk
- Well Diversified
- Big Variations in Year-to-Year Returns
- Bull Market Star, Bear Market Dog
- High Category Risk
- Small Number of Holdings, Industry Concentrations
Peerless Performers: The Top Funds Over 5 Years
by John Markese
Although returns eroded in the last quarter of 2007, each year from 2003 through 2007 recorded positive returns for the average stock mutual fund. Some funds and sectors turned in astonishing five-year returns while other funds languished or declined.
What did it take to be a top fund in the gyrating market environment of the last five years?
To be rated as a top fund required beating a benchmark, and the crucial benchmark is peer group performance. All of the funds listed in this article have outperformed their peers on a five-year annualized return basis.
Just remember: For a fund to be one of the best, it cant look like all the rest. A top fund must distinguish itself by being different. Often, however, being different may mean taking on higher riskfor instance, industry concentration, few holdings, risky strategies, longer maturities, poorer credit risks. That is why a closer look at the funds that outperformed their peer groups is warranted before any investment is made in a top fund.
The Top Funds
Table 1 lists the top funds for each category ranked by total annual return over the last five calendar years through 2007. In order to make the list, a fund must have five years of returns and a five-year annualized return above the category average.
Five years is a sufficient period to test the fund in different market environments, but its also a relatively recent record and therefore still relevant. The categories reported cover the no-load and low-load funds open to new investors that are detailed in AAIIs annual Individual Investors Guide to the Top Mutual Funds (sent to all AAII members each March; the Guide is also available with coverage of an additional 1,000 funds at AAII.com).
For domestic, diversified common stock funds there are three categories denoting company size by market capitalization (common stock shares outstanding times market price per share): large cap, mid cap and small cap.
Sector funds, funds that concentrate in the stocks of one or a few related industries, share the same general strategy and are dominated by their sector emphasis.
International funds can be diversified across many international markets or they can be concentrated in regions or countries. Some are global funds that hold U.S. investments as well as foreign. Some foreign funds invest in developed economies, others in emerging markets.
Balanced funds further stretch the fund class definitions by combining stock and bond holdings. Some balanced funds are target date retirement funds with the portfolio allocations changing to less stocks and more bonds as the target maturity date approaches.
Bond funds can be classified in numerous ways: by the type of bond (mortgage-backed, for example), and by issuer (government, for example) or whether they are foreign or domestic. Some issuersamong government, municipal and corporate groupsare high risk and offer high yield. Tax status is also important, and tax-exempt bonds require a separate classification. Bond maturity is usually another important distinction. The maturity classification for some of these bond fund groups employs the weighted-average maturity of the bonds held in the portfolio: short term (zero to three years), intermediate term (three to 10 years) and long term (over 10 years). Maturity has a significant impact on bond fund performance and risk: Longer-term bond funds are riskier than shorter-term bond funds and they usually offer higher yields.
Category averages appear at the bottom of each category. The category averages are useful as return and risk peer benchmarks to compare against these top funds.
Evaluating the Funds
How should an investor evaluate a mutual fund, assuming the funds investment category is appropriate for the investors portfolio?
First, get the prospectus and read it. Make sure you understand the funds investment objective, investment strategy and risks, and its cost structure.
Next, get an annual or semiannual fund report and look at its actual portfolio holdings. What are the types and number of individual investments and how diversified is the portfolio?
Finally, you need to wrestle with some numbers to better understand how the fund has performed and what risk it has carried.
Table 1 summarizes important numbers that, at a minimum, you should examine.
These funds were tops based on five-year compound annual returns, and the numbers are impressiveeven considering the markets bull run. But a five-year compound annual return hides the actual individual and informative five yearly returns.
What do the individual years reveal?
Often a fund will rise to the top of its peer group due to one or two spectacular annual performances. This performance tends to attract new investments into the fund, and the danger lies in the portfolio managers ability to deploy these new money flows successfullyat times a daunting task. Additionally, a high annual return outdistancing peers followed by a disappointing annual return below the category average or a significantly negative return can shake long-term investors from their long-term financial plan, often to their detriment. Ideally, individual-year returns should show consistent and superior relative performance against the peer mutual fund group. One-year stars often flame out because they took risks different from the other funds in the category, focusing on a few stocks or industries, for example.
Difference From Category
The difference from the category average number (Cat +/-) also gives added meaning to the five-year annual return. CGM Focus returned a compound average of 37.1% over the last five years and outdistanced the large-cap stock average by a whopping 23.5 percentage points. CGM Focus even beat the average each year. Most large-cap stocks are well researched and followed, so almost tripling the peer group average with consistent year-to-year performance above the peer group average is an accomplishment.
The name of the fund alone, however, should be a caution signal. CGM Focus does just that: It focuses on a few industries and holds few stocks24 in all. Recently, the fund was heavily invested in just two industriesindustrial materials and energyand was short, betting on declines in consumer and financial services. This is a high-wire act, although over five years CGM Focus kept their balance. But as an indication of the inherent risk in this approach, the risk of this fund is 2.28 times the risk of the average fund in the large-cap stock category.
How to Judge the Numbers
Top-performing lists can be dangerous to your financial health unless you take the time to carefully analyze the numbers.
When perusing any top-performers list, make sure you understand how a fund managed to thrive over the long term. If it did so by taking a riskier approach, then the possibility of greater returns comes with the possibility of greater return variability.
Bull and Bear Market Returns
Funds and fund categories behave differently in bull markets and bear markets. Some of these funds struggle through bear markets and soar during bull markets.
The point of reference for bull and bear markets is the domestic stock market. For bond funds in general, the bear markets and bull markets are reversedbond funds perform well in bear stock markets and still manage gains in bull stock markets. For example, in the intermediate-term government bond category, the American Century Target Maturity 2015 fund turned in a 45.7% bear market total return while managing a 23.8% bull market total return.
Beware of stock funds that star in bull marketsthere may be a price to pay during bear markets. In the technology sector, the Matthews Asian Technology fund skyrocketed 290.5% in the bull market but detonated in the bear market, down 73.2%. Just remember, however, that if a mutual fund loses 50% of its value one year, it takes a 100% return the next year just to get back to even.
The tax efficiency rating for the five-year period simply tells you what you got to keep out of these returnsassuming maximum federal income and capital gains taxes. The municipal bond funds are the kings of tax efficiencyalthough among stock funds, index funds usually rule.
If the tax efficiency number isnt in the high nineties and you still are interested in the fund, then think IRA, 401(k), and other available shelters.
Investors should always have one eye on return and the other on risk. Dont forget, one way to beat other funds in the categoryalthough there are no guaranteesis to flat out take on more risk than your fund competitors.
The category risk index indicates how much risk the fund carried relative to similar funds, where risk is measured by variation of return. The American Century Target Maturity 2010 topped the short-term government bond category with a 3.9% annual average return over five years, 1.1 percentage points better annually than its peer group, an extraordinary performance difference in a short-term government bond category. But a look at the category risk index for this fund tells much of the story. With a category risk index of 2.29, the American Century Target Maturity 2010 fund is also many heads above its peers in risk. The fund acts like a zero-coupon bonda bond that pays no interest but is sold at a discount and matures at face valuethe most volatile of bond forms when interest rates change.
The best-performing funds are those that have not only outperformed their peers, but also taken on less risk. The Oakmark Global I fund produced a five-year 21.0% average and outpaced its peers by 1.9 percentage points on average annually with a category risk average of only 0.74. The fund even managed a 22.0% positive bear market return, while posting a strong 201.4% bull market return. However, this far-lower risk was achieved with a portfolio far more concentrated than its peers53 holdings for the fund compared to the average of 118. But the funds top 10 holdings made up 32% of the portfolio value, less than the 36% average for the category and indicative of greater diversification.
The total risk index measures the risk of a fund against all categories, all other funds.
For example, U.S. Global Investors World Precious Minerals fund once again topped all the other funds in Table 1 with a total risk index of 3.51, a mountain higher than the average total risk index for all funds of 1.00. Its category risk index, however, is just above average at 1.07. Gold sector funds were the top performers for this five-year period but also carried, by far, the highest total average risk index.
Total risk is useful to compare categories of stock funds to each other for a relative feel of risk. Large-cap stock funds have an average total risk index that is just that, average, at 1.00 compared to the energy sector fund average total risk index of 2.34, for example. Or, from an asset allocation viewpoint, it would be useful to compare stock fund total risk to bond fund total risk: For example, small-cap stock funds have an average total risk index of 1.41, while the average short-term government bond fund has a total risk index of only 0.15.
Total assets of the fund may or may not be at all important, depending on the category and fund approach. A large asset base allows a fund to diversify and have extensive holdings if it chooses.
But with few or illiquid holdings and a large asset base, the ability to trade out of stocks or acquire new positions easily can be adversely affected. Small-cap funds particularly can grow too large. Small-cap stocks are simply less liquid, and large positions in individual small-cap stocks deaden fund flexibility. In the U.S. government bond fund area, the reverse is true: The market is so liquid that, basically, the bigger the fund the better.
Also, while there isnt a perfect correlation, large asset size funds often have lower expenses than peers with less assets.
Number of Holdings
As mentioned, a small number of holdings can mean greater risk. The focus in the CGM Focus fund translated to just 24 stocks and it was even worsethe top 10 holdings constitute 59% of the funds portfolio value. In some unusual cases, however, the number of holdings can translate to the opposite conclusion. Some funds, notably life cycle funds, hold a portfolio of mutual funds. Vanguard LifeStrategy Growth in the balanced domestic category only lists five holdings, but they are each mutual funds so this fund is well diversified. The percent of the portfolio in the top 10 investments in these situations will also be misleading as each investment is in itself a fund, so the 100% in the top 10 investments for the Vanguard LifeStrategy Growth fund is far from alarming.
But even in a portfolio with hundreds of stocks, the fund can be risky if it is heavily invested in a few holdings or concentrated in industries. Thats why looking at an annual report that lists all of the holdings by industry and by percent of the portfolio is useful in gauging risk.
Once again, however, it depends upon the category. The Wasatch-Hoisington U.S. Treasury fund in the long-term government bond category only has 11 holdings, but they are all U.S. government bonds so the low number is meaningless.
Think of the expense ratiofund costs as a percentage of assetsas a hurdle that fund managers must jump. The higher the ratio compared to other funds in the category, the better a fund manager must perform to beat the competition.
Although expense ratios are reflected in returns, extremely high expense ratios are a negative, and very low expense ratios are a long-term positive.
Again, the category makes a difference. High expenses in bond funds are much more difficult to overcome. Its no coincidence that Vanguard bond funds, with rock-bottom expense ratios, are often among the top bond funds.
Know How They Got There
Lists of top-performing funds can be dangerous to investors. The temptation to invest in the top fundswithout understanding why they made the listis powerful. Avoid the temptation. Do your homework, and find out how the fund made the list before you commit your assets.