The Top Funds Over 5 Years: Surviving the Claws of a Bear Market

    by John Markese

    The Top Funds Over 5 Years: Surviving The Claws Of A Bear Market Splash image

    Focusing on a single year’s performance for a fund can lead to less than optimal long-term investment decisions, particularly when the performance for the year is a runaway hit or, as in 2008, simply dismal. Five-year fund performances put fund managers to the test of how their strategies work in varied market environments, and the last five years have been nothing if not varied.

    So, what did it take to be a top fund in the trying—and, at times, chaotic—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 can’t look like all the rest. A top fund must distinguish itself by being different. Often, however, being different may mean taking on higher risk—for 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 2008; index returns appear at the end of the listing for comparison (page 12). 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 1,000 funds at

    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.

       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
    • 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

    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 (general or emerging markets) 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 of the fund 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 surprising considering the stock market’s sickening drop in 2008. 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 manager’s ability to deploy these new money flows successfully—at 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.

    In the mid-cap stock category, Gabelli ABC fund managed a compound average annual five-year return of 4.5%, with a mid-cap average fund performance for the period of –1.4%. This translates to a difference from the category average of 5.9% a year on average, but this was primarily due to a loss of only 2.7% in 2008 when the average loss for the category was 40.3%. The Gabelli ABC fund lagged the category average in every year but 2008. One explanation of this underperformance for four years is that the fund is simply low risk compared to its peers and that this low risk served it well in the collapsing market of 2008. The fund holds nearly 170 individual stocks although it has just over 50% of its assets in its top 10 holdings. The Gabelli ABC fund also has a very high turnover ratio for the portfolio, around 200%, meaning that the fund trades stocks relatively rapidly. This strategy has apparently worked only one year in five.

    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 reversed—bond funds perform well in bear stock markets and still manage gains in bull stock markets. For example, the T. Rowe Price U.S. Treasury Intermediate fund returned 12.0% during the bull market (from March 1, 2003, to October 31, 2007) and 18.4% for the bear market (November 1, 2007, to December 31, 2008).

    Beware of stock funds that star in bull markets—there may be a price to pay during bear markets. Fidelity Emerging Markets fund rose 467.3% during the bull market but fell 63.0% during the bear market, down 60.9% in 2008. But if you were invested in the fund from the beginning of 2004 and remained invested for all five years, your average annual compound return would still have been 6.1%. Investing in late 2007 would have produced a horrendous return.

    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 the fund carried relative to similar funds, where risk is measured by variation of return. The CGM Focus fund was the top-performing large-cap stock fund again, but its category risk index of 1.88—compared to the average category risk index of 1.00—tells an important story. With only 22 stocks in its portfolio, it lives up to the word “focus” in its name; and with 64% of its investments in its top 10 holdings, it should be no surprise that it is almost twice as risky as its peers. In 2007, it gained 79.9% and in 2008 it lost 48.2%, a sickening ride and hard to hold on for most investors in the short run, yet it still beat all funds in its category over five years.

    The best-performing funds are those that have not only outperformed their peers, but also taken on less risk. Both the Gabelli ABC fund, with a category risk index of 0.22, and the Pinnacle Value fund, with a category risk index of 0.43, have done just that. They both performed far better than their peers in the bear market, down 3.0% and 17.9%, respectively.

    Total Risk

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

    For example, the USAA Precious Metals and Minerals fund, a gold sector fund, had a total risk index of 2.64, where the average fund no matter what the category—stock or bond, domestic or foreign—had a total risk index of 1.00. However, USAA’s total risk index is just slightly below the 2.65 total risk index average for gold funds. Gold funds carried the highest total risk of all funds for the five years, but were outperformed by energy funds (oil) over five years. But energy funds had an average total risk index of 2.03.

    Total risk is useful to compare categories of stock funds to each other for a relative feel of risk. For example, health care sector funds averaged 1.00 in total risk, right at the average for all mutual funds, while emerging market funds averaged 2.03 and real estate sector funds averaged 1.77. Or, from an asset allocation viewpoint, it would be useful to compare stock fund total risk to bond fund total risk: For example, large-cap funds averaged a total risk index of 1.05, just above the average for all funds, while general long-term bond funds had a total risk index that averaged 0.48, less than half the average risk, and short-term U.S. government bonds had a total risk index of just 0.11.

    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. The focus in the CGM Focus fund translated to just 22 stocks, with the top 10 holdings comprising 64% of the total value of the portfolio. In some unusual cases, however, the number of holdings can translate to the opposite conclusion. Some funds, notably life cycle funds and target date funds, hold a portfolio of mutual funds. The Vanguard Target Retirement Income fund in the target date 2000–2014 category only lists eight 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 100% in the top 10 investments for a target date 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. 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, it depends upon the category. The Vanguard Inflation-Protected Securities fund only holds 25 bonds, but they are all U.S. government bonds and notes with various maturities, so the small number of holdings doesn’t increase risk in this case.

    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 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 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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