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    Top Funds Over Five Years: Analyzing How They Got There

    by John Markese

    Top Funds Over Five Years: Analyzing How They Got There Splash image

    The last five years have proven to be a rigorous test track for mutual funds and mutual fund investors. It seemed that every imaginable contingency, and others that were hitherto unimaginable, was thrown in the path of mutual funds and investors.

    Some funds broke down along the way, some struggled to complete the course and a few easily passed the test; the same for investors.

    It is instrumental for future investment decisions to put the top funds over the last five years up on the rack and take a closer look to see how they fared and how they were built.

    What made them the best funds on a return basis compared to other funds with similar specifications? 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 means simply taking higher risk—industry concentration, few holdings, risky strategies, longer maturities, poorer credit risks.

    The Top Funds

    Table 1 lists the top funds for selected categories ranked by total return over the last five calendar years. The categories reported cover the majority of funds as 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 under the Mutual Fund education area).

    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, have 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 by regions or countries.

    Bond funds can be classified in numerous ways, but two categories—U.S. government and national tax-exempt municipal bonds—represent the majority of bond fund assets. An additional classification for these bond funds groups them by 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.

    Indexes for comparisons are provided at the end of Table 1. The indexes incur no transaction costs or expenses, are unmanaged, and are useful as return and risk benchmarks to compare against these top funds. The large-cap stock fund benchmark is the Standard & Poor’s 500 index; the mid-cap benchmark is the Standard & Poor’s MidCap 400; and the small-cap benchmark is the Russell 2000. There is no one appropriate benchmark for sector stock funds. The MSCI EAFE is the international stock benchmark and each of the U.S. government and municipal bond maturity categories has a Lehman bond index benchmark for comparison.

    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 semi-annual fund report and look at its actual portfolio holdings. What are the individual investments and how diversified is the portfolio?

    Next, 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. 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 52.8% loss (Matthews Korea fund in year 2000), or a 237.4% gain (Fidelity Japan Smaller Company fund in 1999)? In the latter case, the fund’s five-year annual return of 12.1% gives not a hint of the year-to-year gyrations in return.

    Difference From Category
    The difference from the category average number (Cat +/-) also gives added granularity to the five-year annual return. The Oakmark Select fund, with its 13.0% five-year annual return, beat its category, large-cap stock funds, by 13.9%. Two things are clear: This is an enormous difference on a five-year annual number. If the return for the fund was 13.0% and the difference from category was 13.9%, then the average fund in the category lost 0.9% a year over the last five years.

    Drop down the list and take a look at the difference from category for the Vanguard Limited Term Tax-Exempt Bond fund, 0.8%. At first glance this difference may seem small, but be sure to consider that this is a short-term bond fund where returns historically are significantly lower than for longer-term bond funds and much lower than for stock funds. Being 0.8% better than the category, on average, can be just as meaningful as being 13.9% better.

    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 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, Fidelity New Millennium fund has a category risk index of 1.84, indicating 84% more risk than average for the category, 1.00.

    The best-performing funds are those that have outperformed their peers while taking on less risk. The Clipper fund, for example, has a category risk level of 0.81.

    Total Risk
    The total risk index measures the risk of a fund against all categories, all other funds. In the Fidelity New Millennium example, the total risk index is 2.22—even higher than its category risk index because its category is riskier than the average category.

    Conversely, the Vanguard Limited Term Tax Exempt fund has a category risk index of 1.40, but because short-term bond funds are one of the least risky of all funds, its total risk index is only 0.12—barely registering on the fund total risk scale.

    Total Assets
    Total assets of the fund may or may not be at all important, depending on the category and fund approach. The Oakmark Select fund, with only 19 holdings—concentrated holdings is their stated strategy—has $4.3 billion and is closed to new investors.

    With few holdings, even in the large-cap area, too much in assets can adversely affect fund liquidity, the ability to trade out of stocks or acquire new positions easily. In the small-cap area it is crucial, and four out of the five top funds are closed to new investors. (Consult your Individual Investor’s Guide to the Top Mutual Funds for more top small-cap funds.) Small-cap stocks are simply less liquid and large positions in small-cap stocks deaden fund flexibility.

    While it isn’t a perfect correlation, large asset size funds often have lower expenses than peers with less in assets. In the U.S. government bond fund area, the market is so liquid that, basically, the bigger the better.

    Number of Holdings
    As mentioned, a small number of holdings can mean greater risk. 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 American Century Target 2015 maturity fund only holds 10 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 stay even with the competition.

    Extremely high expense ratios are a negative, and very low expense ratios are a long-term positive. And 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 third of the top bond funds.

    Know How They Got There

    Lists of top-performing funds that don’t go into more performance detail can be dangerous to investors. The temptation to invest in the top funds without understanding why they made the list is great.

    Avoid the temptation. Do your homework, and get to know the fund before you commit your assets.


    John Markese is president of AAII.


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