Close

The Top Funds Over Five Years: Finding Common Themes in a Volatile Market

by Charles Rotblut, CFA

The Top Funds Over Five Years: Finding Common Themes In A Volatile Market Splash image

The past five years have truly tested the skills of mutual fund managers.

The equity markets went from boom to bust to rebound. The bond markets also fluctuated, especially in the high-yield spectrum. Emerging markets enjoyed strong economic growth. Then there were the commodity markets, which saw a bubble and a bust in the same calendar year.

The upside to this is that investors now have a recent track record to judge how a fund performed in varying types of markets. Did the fund react well to rising markets? Are the losses experienced during the recent bear market acceptable? Can the fund consistently beat its benchmark, or is its performance dictated solely by the type of conditions the manager is facing?

These are all important questions to consider when evaluating a fund. Though the temptation might be to pick a fund based on its five-year performance, the reality is that the fund could experience large variances on a year-to-year basis. Therefore, take a close look at the annual returns and the volatility. Not every fund is suitable for every investor.

Table 1 presents the mutual funds with the best five-year performance overall and for each category as culled from AAII’s “Individual Investor’s Guide to the Top Mutual Funds” (sent to all members in February).

The list of the top five funds overall at the top of the table is presented solely for informational purposes, especially since past performance is no guarantee of future returns.

A common theme among these top funds is emerging markets. Two focus on Latin America, T. Rowe Price Latin America (PRLAX) and Fidelity Latin America (FLATX), and one targets China, Matthews China (MCHFX). Though investing overseas can add to diversification, valuation, political risks and currency exchange rates are all factors that must be considered.

The other two funds targeted mining companies, USAA Precious Metals & Mining (USAGX) and Tocqueville Gold (TGLDX). Owning gold companies is not the same as owning the precious metal itself, and production costs, labor unrest and political instability can all result in returns different than expected. As of this writing, TGLDX has 9.5% of its portfolio invested in physical gold. (Read the fund’s prospectus for the tax treatment of distributions.)

Keep an eye on volatility with these funds. PRLAX, FLATX and MCHFX lost approximately 60% of their value during the recent bear market. They also took on more risk than their peers, as is evident by the category risk index scores. Though the extra risk helped the funds to achieve impressive five-year gains, the performance did not occur without giving shareholders a bad case of heartburn.

Table 1 presents the mutual funds with the best five-year performance overall and for each category as culled from AAII’s “Individual Investor’s Guide to the Top Mutual Funds” (sent to all members in February).

The list of the top five funds overall at the top of the table is presented solely for informational purposes, especially since past performance is no guarantee of future returns.

A common theme among these top funds is emerging markets. Two focus on Latin America, T. Rowe Price Latin America (PRLAX) and Fidelity Latin America (FLATX), and one targets China, Matthews China (MCHFX). Though investing overseas can add to diversification, valuation, political risks and currency exchange rates are all factors that must be considered.

The other two funds targeted mining companies, USAA Precious Metals & Mining (USAGX) and Tocqueville Gold (TGLDX). Owning gold companies is not the same as owning the precious metal itself, and production costs, labor unrest and political instability can all result in returns different than expected. As of this writing, TGLDX has 9.5% of its portfolio invested in physical gold. (Read the fund’s prospectus for the tax treatment of distributions.)

Keep an eye on volatility with these funds. PRLAX, FLATX and MCHFX lost approximately 60% of their value during the recent bear market. They also took on more risk than their peers, as is evident by the category risk index scores. Though the extra risk helped the funds to achieve impressive five-year gains, the performance did not occur without giving shareholders a bad case of heartburn.

The Top Categories

Table 2 presents the average five-year return and total risk index for each fund category. One trend shown by the data is that diversification worked. The top 10 categories on this list provide exposure to commodities, international markets and government bonds.

Fund Category 5-Yr Annual Avg Return (%) Total Risk Index (X)
Gold Sector 16.1 2.38
Emerging Stock 13.4 1.86
Energy/Resources Sector 10.3 1.81
International Bond: Emerging 7.9 0.73
Regional/Country Stock 7.4 1.62
Gov't Bond: Intermed-Term 4.7 0.24
Utilities Sector 4.7 0.95
Corporate High-Yield Bond 4.6 0.68
Gov't Bond: Long-Term 4.4 0.86
Foreign Stock 4.4 1.32
Health Sector 4.3 1.00
Convertible Bond 4.3 0.85
General Bond: Intermed-Term 4.3 0.27
General Bond: Long-Term 4.2 0.44
Inflation-Protected Bond 4.2 0.45
Mortgage-Backed Bond 4.0 0.18
International Bond: General 4.0 0.42
Muni Nat'l: Long-Term Bond 3.7 0.33
Gov't Bond: Short-Term 3.5 0.10
Muni Nat'l: Intermed-Term Bond 3.5 0.25
Global Stock 3.4 1.15
Target Date: 2000-2014 3.4 0.52
Technology Sector 3.2 1.34
Balanced: Domestic 3.0 0.68
Telecommunications Sector 3.0 1.32
Balanced: Global 2.9 0.85
Muni Nat'l: Short-Term Bond 2.8 0.10
General Bond: Short-Term 2.7 0.21
Target Date: 2015-2029 2.7 0.81
Muni Nat'l: High-Yield Bond 2.4 0.53
Long-Short 2.4 0.56
Target Date: 2030+ 2.3 1.02
Miscellaneous Sector 2.2 1.38
Mid-Cap Stock 1.8 1.19
Large-Cap Stock 0.8 1.09
Small-Cap Stock 0.7 1.29
Real Estate Sector -1.2 1.91
Contra Market -6.3 1.46
Financial/Banking Sector -7.6 1.45

As stated in my Editor’s Note in this issue, a portfolio comprised of 20% commodity stock funds, 30% international stock funds, 20% government bond funds, 10% emerging market bond funds, 10% utilities funds and 10% corporate high-yield bond funds would have generated a five-year annualized return of 7.8%. If one were to modify the portfolio slightly and include both health care stock funds and convertible bond funds (the 11th and 12th best-performing categories), annualized performance would still have been an impressive 7.2%.

Though the returns are theoretical (actual performance was dependant on the funds selected and could have been better or worse), they do show the benefit that diversification produces. A portfolio holding only large-cap stocks would have essentially been unchanged, in terms of value, over the past five years.

SPECIAL OFFER: Get AAII membership FREE for 30 days!
Get full access to AAII.com, including our market-beating Model Stock Portfolio, currently outperforming the S&P 500 by 4-to-1. Plus 60 stock screens based on the winning strategies of legendary investors like Warren Start your trial now and get immediate access to our market-beating Model Stock Portfolio (beating the S&P 500 4-to-1) plus 60 stock screens based on the strategies of legendary investors like Warren Buffett and Benjamin Graham. PLUS get unbiased investor education with our award-winning AAII Journal, our comprehensive ETF Guide and more – FREE for 30 days
sign-up

Again, past performance is no guarantee of future returns. Some of the categories and funds that did particularly well over the last five years may lag during the first half of this decade. Conversely, a category that performed poorly may rebound. Since it is impossible to know, including a mix of different types of funds increases the odds of being in the “right” category at the “right” time.

This said, your health, wealth and age should all play a bigger determinant in which categories to target than performance. Emerging market countries, such as Brazil, may be showing stronger economic growth right now, but if cash preservation and income are top priorities, a large allocation to an emerging market stock fund may not make much sense. Conversely, an investor who does not intend to access funds in his portfolio for 20 years or longer should consider the outlook for interest rates before investing heavily in bond funds just because of their recent five-year performance.

Fund Listings

The top funds for each category are presented in Table 1. Along with the five-year compound annual return, we report 10 years of annual return data. This allows you to see how the fund performed during both the past two bear markets and the resulting rebounds. Returns in bold are in the top 25% of all funds within the investment category. Risk and expense ratios in bold are in the lowest 25% in the category.

Analyzing Performance

There are several things to consider when evaluating a mutual fund. Total return is obviously important, but return is relative to a fund’s category. A fund in a more conservative category may have a lower total return, but it may do a better job of preserving capital. Conversely, a fund in a more aggressive category may have a higher five-year performance, but it also could have lost a significant amount money during the recent bear market.

For example, consider Vanguard Short-Term Federal (VSGBX), a short-term government bond fund, versus Janus Orion (JORNX), a mid-cap stock fund. VSGBX has a five-year return of 4.6% and produced positive annual returns during each of the past five years. JORNX made investors more money with a five-year return of 8.1%, but it also experienced a 49.8% drop in 2008. In other words, the better long-term performance came at a price.

In both cases, actual performance was influenced by the type of investments held by the funds. Treasuries, held by VSGBX, provided investors safety and benefited from falling yields during the recent bear market. Mid-cap stocks, held by JORNX, fluctuated with the broader equity markets, losing significant ground during the bear market, only to rebound strongly last year.

What separates both funds from their peers, however, is the consistency of their relative performance. VSGBX ranked among the best-performing government short-term funds in its category during each of the past five years. JORNX ranked among the best performing mid-cap stock funds during four out the last five years. In other words, the funds’ managers have shown the ability to consistently beat their peers.

The Cat +/- (“difference from category”) columns show how a fund performed relative to its category. A fund that beats its category average during good years and trails it during down years likely takes on more risk than its peers. This can lead to more volatile returns.

Other Factors to Consider

Top-performing lists can be dangerous to your financial health unless you take the time to carefully analyze the numbers.

 

 

How to Judge The Numbers

Less Risk

  • Low Expense Ratios
  • High Tax Efficiency
  • Consistently Good Performance Year-to-Year Relative to Similar Funds
  • Low Category Risk
  • Well Diversified

More Risk

  • Big Variations in Year-to-Year Returns
  • Bull Market Star, Bear Market Dog
  • High Category Risk
  • Small Number of Holdings, Industry Concentrations

 

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.

The tax-cost ratio measures how much a fund’s annualized return is reduced by taxes paid on distributions. A lower ratio suggests the fund is more tax-efficient and improves the actual return realized by investors holding the fund in a taxable account. Investors owning both taxable and non-taxable accounts (e.g., IRAs) should consider holding funds with higher tax-cost ratios in the non-taxable account.

Returns are also influenced by expense ratios and loads. All things being equal, lower expenses are preferable. However, a higher expense or load may be justified. Some asset categories (e.g., emerging market stocks and bonds) incur greater costs than others (e.g., short-term U.S. government bonds). Expense ratios that are above the category average may be justified if performance is high enough to offset the costs. Finally, keep in mind that the performance ratios factor in expense ratios, but not load fees.

Total assets and the number of holdings provide insight as to how big the fund is. There is no magic number for either, but a fund that is too big or too small could incur problems. A fund that is too large may be forced to acquire larger positions or invest in lower-quality securities than the manager prefers. A fund that is too small could potentially be invested in too few securities, increasing risk. There is also a higher potential of the fund being folded into a larger fund. Smaller funds may also have higher expense ratios due to higher relative overhead costs.

Further Evaluation

Before investing in any fund, read the prospectus. Have a clear understanding of the fund’s objective, strategy, risks and cost structure.

Next, obtain the latest fund report and review the holdings. What does the fund hold? How much of the portfolio is concentrated in each of the key holdings? If the fund manager provides commentary, read it to get additional insight into the thought process.

Finally, remember that just because mutual funds are intended to be long-term holdings, you should never buy them and forget about them. Like any investment, mutual funds should be periodically monitored to make sure the objective has not changed and the fund is performing as expected given prevailing market conditions and historical performance. Do not only pay attention to current performance, but also current performance relative to historical performance and the fund’s category average. A fund that lags in market conditions that it historically has done well in should receive more scrutiny than a fund that is following its historical volatility trends and is producing similar returns to those of its peers.

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

D. from MD posted over 4 years ago:

Table 1 is a blank dark grey blob. The background color needs to be much lighter. So far I've found this to be the case quite often on the AAII website.

I'm using a laptop with an LCD screen.


James Cogil from IA posted about 1 year ago:

The columns for annual total returns show only the years through 2009. Shouldn't this chart show 2010 through 2012 too. Please correct or explain. Thanks


Jean Henrich from IL posted about 1 year ago:

James - this article is from 2010, that's why the data stops at 2009. The newest list of best 5-year funds was published in the March 2013 AAII Journal and can currently be found at the AAII Journal page: http://www.aaii.com/journal

Here's the direct link to the article:
http://www.aaii.com/journal/article/the-top-mutual-funds-over-five-years-the-bears-claw-marks-remain

--Jean from AAII


You need to log in as a registered AAII user before commenting.
Create an account

Log In