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    The Top Funds Over Five Years: 2001-2005 Survival of the Fittest

    by John Markese

    The Top Funds Over Five Years: 2001 2005 Survival Of The Fittest Splash image

    The last five years provided the ultimate financial stress test for mutual funds and investors—two bear years followed by three bull years.

    Some funds flunked the test, and a few proved to be in top shape. For investors, the last five years on the market treadmill raised everyone’s pulse.

    It can be illuminating for future investment decisions to analyze the best results for the funds over the last five years to see why they fared so well.

    What made them the top-performing results for the funds compared to a peer group of 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 2005.

    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; 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.

    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. 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—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 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. What about the FBR Gas Utility Index fund’s loss of 23.9% in 2002? It fared better than the average loss of 25.6% for all utility sector funds that year, but surely it would have been a surprise to many utility fund investors expecting relative return stability. At the other extreme, Oberweis Micro Cap fund returned 108.9% in 2003 but only 2.1% in 2004 for a five-year annual compound average return of 19.7%. 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 granularity to the five-year annual return. Oakmark Select fund in the large-cap stock category managed to outperform the category by 9.5% a year on average over the last five years. Given that large-cap stocks are the most researched and followed, this is quite an accomplishment. Equally impressive is Wells Fargo Advantage Short Term Municipal Bond fund, which beat its category average by 1.2% a year on average over the last five years. At first glance that may not seem like much added value, but due to the tax benefit of municipal bonds funds and, in this case, the short-term nature, average returns are normally low compared to other bond funds. When the top fund in the category produces a five-year average return of 4.0% and manages to outperform the category by 1.2% a year, the accomplishment is extraordinary.

    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 2005.

    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 Bond Index fund in the general bond fund category turned in a 39.6% return in the bear market period and still managed a 17.0% return during the bull market period.

    Beware of stock funds that star in bull markets—there may be a price to pay during bear markets. The Baron iOpportunity fund in the technology sector category scored a 139.9% return in the bull market period, but dropped 58.7% during the bear period, although this was better than the average bear period decline for this sector of a shocking 75.7%.

    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. For example, the Fidelity Leveraged Company Stock fund has a category risk of 1.44, which means it has a 44% higher risk than the average fund in the mid-cap stock category. The word “leveraged” in the fund name should be a hint.

    The best-performing funds are those that have not only outperformed their peers, but also taken on less risk. The Janus Mid Cap Value fund made the mid-cap stock fund top five list with a category risk index of only 0.84, far different than the 1.44 category risk index of the top fund, Fidelity Leveraged Company Stock fund.

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

    For example, US Global Investment World Precious Metals fund had a total risk index of 3.18—the highest of all these top funds—but a category risk index of only 1.10. Gold funds are usually the most volatile of all funds but the US Global Gold fund is only just above average in category risk.

    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 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 46 stocks and spreads out $1.6 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, the fund can be risky if it is concentrated 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 11 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 significant portion 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.

       Survival Guide
    When perusing any top-performers list, make sure you understand how a fund managed to survive over the long term. If it did so by taking a riskier approach, then you are paying a steep price for the possibility of greater returns.

    Calmer Approach to Survival

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

    Stressful Approach to Survival

    • 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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