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    Mutual Fund Marathon: The Top Funds Over Five Years: 2002-2006

    by John Markese

    Mutual Fund Marathon: The Top Funds Over Five Years: 2002 2006 Splash image

    The bears have dominated the market over the last month or two, but the last five years were dominated by a bull market for common stocks—one bear year followed by four bull years. Over these years, some funds thrilled, others withered. And for long-term investors, it is the marathon winner, not the short-term sprinter, that counts.

    To be a top fund requires beating a benchmark, and that benchmark is peer group performance. 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 2006. 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 it’s 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 AAII’s annual Individual Investor’s Guide to the Top Mutual Funds (sent to all AAII members each March; the Guide is also available with coverage of an additional 850 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 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: 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 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 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.

    Year-by-Year Returns

    These funds were tops based on five-year compound annual returns, and the numbers are impressive—even considering the market’s bull run during the last four of 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 one-year losses and some of these losses might have stunned fund investors at the time. Other funds may have had one-year gains that momentarily dazzled investors.

    T. Rowe Price Media and Telecommunications fund (PRMTX) lost 28.3% in 2002, a significant hit for investors, but the category average was much worse at a negative 40.8%. The fund, however, rebounded with the rest of the market, up 55.9% in 2003, and registered a five-year compound average annual return of 16.4%. But that 28.3% loss undoubtedly shook a lot of investors out of the fund and caused them to miss the upswing. Five-year returns can mask the year-to-year variability of fund returns.

    Difference From Category

    The difference from the category average number (Cat +/-) also gives added meaning to the five-year annual return. American Beacon Large-Cap Value PlanAhead (AAGPX) is a large-cap fund that outperformed its peer group by an average of 6.0% a year over five years. Its five-year annual average return was 11.9% and the category average was 5.9%. Most large-cap stocks are well researched and followed, so more than doubling the peer group average with consistent year-to-year performance above the peer group average is an accomplishment.

    In the regional/country category, the T. Rowe Price Emerging Europe and Mediterranean fund (TREMX) bested the category average by a phenomenal 17.3% a year on average over five years. However, there are very few funds in this category that concentrate their portfolio holdings in this area. The economies of Latin America and Korea, for example, are not comparable to Russia, a country with close to a 40% portfolio weight in this fund.

    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 2006.

    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, in the intermediate-term government bond category, the American Century Target Maturity 2015 fund (BTFTX) turned in a bear market return of 45.6% and still managed a bull market return of 16.8%.

    Beware of stock funds that star in bull markets—there may be a price to pay during bear markets. In the mid-cap stock fund category, the Hodges fund (HDPMX) lost 53.9% in the bear market but soared 242.8% in the ensuing bull market. Just remember, however, that if a fund loses 50% of its value one year, it takes a 100% return the next year just to get back to even.

    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.

    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. The American Century Target Maturity 2010 (BTTNX) topped the short-term government bond category with a 5.7% annual average return over five years, 2.7% better annually than its peer group, an extraordinary performance difference in a short-term bond category. But a look at the category risk index for this fund tells much of the story. With a category risk index of 3.0, the American Century Target Maturity 2010 fund is also many heads above its peers in risk. The fund acts like a zero-coupon bond—a bond that pays no interest but is sold at a discount and matures at face value—the 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. Remember the American Beacon Large Cap Value PlanAhead fund (AAGPX) and its exceptional and consistent performance relative to its category peers? Its category risk index is only 0.83, well below average, making its performance on a risk basis all the more impressive.

    Total Risk

    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 (UNWPX) once again topped all the other funds in Table 1 with a total risk index of 3.59, 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 1.03. Gold sector funds were the top performers for this five-year period but also carried, by far, the highest total average risk index.

    Total Assets

    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 isn’t 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. For example, the top-performing large-cap fund, the CGM Focus fund (CGMFX) returned on average 17.2% a year over the five-year span, an impressive 11.3% annually on average greater than the large-cap category average. However, the word “focus” in its name is a giveaway. It spreads its $2.2 billion in assets only over 26 stocks and over 50% of its holdings are in two sectors, energy and industrial materials. 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. 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 Rydex Government Long Bond Advantage fund (RYGBX) in the long-term government bond category only has five holdings, but they are all U.S. government bonds so the low number is meaningless.

    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.

    Again, the category makes a difference. High expenses in bond funds are much more difficult to overcome. It’s no coincidence that Vanguard bond funds, with rock-bottom expense ratios, are 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 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.

       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.

    Less Risk

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


    John Markese is president of AAII.


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