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    The Top Funds Over Five Years: What Made Them Different?

    by John Markese

    The Top Funds Over Five Years: What Made Them Different? Splash image

    The last five years have proven to be a particularly rigorous test track for mutual funds and mutual fund investors.

    Some funds broke down along the way and some struggled to complete the course. A few made it easily to the top. The same is true for investors.

    It can be illuminating for future investment decisions to put the top funds over the last five years up on the rack to examine why they fared so well.

    What made them the top-performing funds on a return basis compared to other similar funds?

    Just remember: For a fund to be one of the best, it can’t look like all the rest. A top fund must distinguish itself by being different. Often, however, being different simply means taking on higher risk—for instance, industry concentration, few holdings, risky strategies, longer maturities, poorer credit risks.

    The Top Funds

    Table 1 lists the top funds for each category ranked by total annual return over the last five calendar years through 2004.

    Five years is a sufficient period to test the fund in different market environments, but it’s also a relatively recent record and therefore still relevant. The categories reported cover the funds open to new investors that are detailed in AAII’s annual Individual Investor’s Guide to the Top Mutual Funds (sent to all AAII members each March and available 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 but 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.

    Bond funds can be classified in numerous ways: by the type of bond (mortgage-backed, for example), and by issuer (corporate or government, for example) or whether they are foreign or domestic. Some issuers—among government, municipal and corporate groups—are 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.

    Balanced funds further stretch the fund class definitions by combining stock and bond holdings. Category averages appear at the bottom of each category. The category averages are useful as return and risk benchmarks to compare against these top funds.

    Evaluating the Funds

    How should an investor evaluate a mutual fund, assuming the fund’s investment category is appropriate for the investor’s portfolio?

    First, get the prospectus and read it. Make sure you understand the fund’s 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 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.

    One-Year Returns
    These funds were tops based on five-year compound annual returns, and the numbers are impressive—particularly considering the market’s perilous journey during those five years. But a five-year compound annual return hides the actual individual and informative five yearly returns.

    What do the individual years reveal?
    A few of these funds had losses in three out of five years and some of the losses might have stunned fund investors at the time. Other funds may have had one-year gains that momentarily dazzled investors. How about a 32.9% loss (Fidelity Emerging Markets fund in 2000), or a 99.5% gain (US Global Investors Global Resources sector fund in 2003)? In the latter case, the fund’s impressive five-year annual return of 24.0% gives not a hint of the year-to-year gyrations in return or the one-year home-run return.

    Difference From Category
    The difference from the category average number (Cat +/-) also gives added granularity to the five-year annual return. The Yacktman fund (in the large-cap category), with its 17.1% five-year annual return, beat its category, large-cap stock funds, by 18.8%. Two things are clear: This is an enormous difference on a five-year annual number. If the return for the fund was 17.1% and the difference from category was 18.8%, then the average fund in the category lost on average 1.7% a year over the last five years.

    Take a look at the difference from category for the Strong Short-Term Municipal Bond fund, 1.1%. At first glance this difference may seem small. But keep in mind that this is a short-term municipal bond fund, where returns historically are significantly lower than for taxable funds and for longer-term bond funds and much lower than for stock funds. Being 1.1% better than the category, on average, can be just as meaningful as being 18.8% better.

    Bull and Bear Market Returns
    Funds and fund categories behave differently in bull markets and bear markets. Some of these funds struggled through the bear market that started in April of 2000 and ended in February of 2003, and soared during the bull market that commenced in March of 2003 and continued through 2004.

    But 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 reversed—bond funds perform well in bear stock markets and still manage gains in bull stock markets. For example, the Vanguard Long-Term Investment-Grade Bond fund (in the corporate bond category) was up 39.2% in the bear market, but still up 12.2% in the bull market. Interest rates mostly cooperated with bond funds over the last five years: They fell.

    Beware of stock funds that star in bull markets—there may be a price to pay during bear markets. The Vanguard Emerging Markets Stock Index fund was up 106.4% during the bull market, but suffered a 35.7% decline during the bear market. And as if you already didn’t know how well real estate has done over the last five years, the top sector fund, CGM Realty, has a bull market return of 152.0% and a bear market return of 40.5%—an outstanding and highly unusual record.

       THE ROAD TO THE TOP
    When perusing any top-performers list, make sure you understand how a fund made it to the top. If it did so by taking a riskier path, then you are paying a steep price for the possibility of greater returns.

    Smooth Roads to the Top

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

    Rocky Roads to the Top

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

    Tax Efficiency
    The tax efficiency rating for the five-year period simply tells you what you got to keep out of these returns—assuming maximum federal income and capital gains taxes. The municipal bond funds are the kings of tax efficiency—although among stock funds, index funds usually rule.

    If the tax efficiency number isn’t in the high nineties and you still are interested in the fund then think IRA, 401(k), and other available shelters for investments.

    Category Risk
    Investors should always have one eye on return and the other on risk. Don’t forget, one way to beat other funds in the category—although there are no guarantees—is to flat out take on more risk than your fund competitors.

    The category risk index indicates how much risk relative to similar funds the fund carried, where risk is measured by variation of return. For example, the Vanguard Long-Term Investment Grade Bond fund (in the corporate bond category) has a category risk index of 2.31, indicating 131% more risk than average for the category, 1.00.

    The best-performing funds are those that have not only outperformed their peers, but also taken on less risk. The Fidelity Canada fund, for example, has a category risk level of 0.80.

    Total Risk
    The total risk index measures the risk of a fund against all categories, all other funds.

    USAA Precious Metals and Mining, for example, has a total risk index of 2.48—the highest listed, but its category risk index is only just below the average for the category at 0.99.

    Conversely, the Scudder High-Income Plus fund has a category risk index of 1.15, but high-yield bond funds generate a lot of consistent income. It is relatively low risk when compared to all funds with a total risk index of 0.49.

    Total Assets
    Total assets of the fund may or may not be at all important, depending on the category and fund approach. But a large asset base allows a fund to diversify and have extensive holdings if it chooses.

    With few holdings, even in the large-cap area, a large asset base can adversely affect the liquidity of the fund’s investments, the ability to trade out of stocks or acquire new positions easily. Small-cap stocks are simply less liquid, and large positions in individual small-cap stocks deaden fund flexibility. Small-cap funds can grow too large. In the U.S. government bond fund area, the market is so liquid that, basically, the bigger the fund the better.

    While it isn’t a perfect correlation, large asset size funds often have lower expenses than peers with less in assets.

    Number of Holdings
    As mentioned, a small number of holdings can mean greater risk. The CGM Focus fund in the small-cap area only holds 27 stocks and spreads out nearly a billion dollars over their holdings, increasing risk and the potential for impact on these stock prices when trading in or out of positions. But even in a portfolio with hundreds of stocks, concentrations can still be dangerous if they are only in a few holdings or industries. That’s 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 only holds 13 securities, but they are U.S. government bonds so the low number is meaningless for risk.

    Expense Ratio
    Think of the expense ratio—fund costs as a percentage of assets—as 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.

    Once again, the category makes a difference. High expenses in the bond categories are much more difficult to overcome. It is no coincidence that Vanguard bond funds, with their rock bottom expense ratios, make up a quarter of 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 funds—without understanding why they made the list—is powerful. Avoid the temptation. Do your homework, and find out how the fund made the list before you commit your assets.


    John Markese is president of AAII.

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