Charles Rotblut will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
Context is always important when looking at historical return data, especially five-year performance for mutual funds.
The period covered in this year’s Top Funds Over Five Years article starts on January 1, 2007—months before the severe bear market started. As of the end of 2011, neither the S&P 500 index nor the broader Wilshire 5000 index had rebounded back to the price levels they traded at at the start of the five-year period that this article covers.
The five-year period also saw a large drop in interest rates. Yields on the benchmark 10-year Treasury bond fell from 4.71% on December 29, 2006, to 1.87% on December 30, 2011. Since bond yields and prices are inversely related, bonds rallied over the past five years.
Given this backdrop, it should be no surprise that bond funds dominate this year’s list of the mutual funds with the best five-year performance. Out of the 10 top-ranking mutual fund categories, nine are in the bond arena. The only category preventing a clean sweep in the top 10 is the gold sector. Yet even gold lost some of its luster, falling from the top spot in last year’s ranking to ninth place in this year’s ranking.
Stock fund categories barely make an appearance in the top half of the performance rankings. The health care sector, which is less economically sensitive, elbowed its way into the 12th spot, while the technology sector does not appear until the 18th spot. To put these rankings into perspective, we track performance for 39 categories, shown in Table 1.
The three mutual funds with the best five-year performance share the common trait of focusing on long-term bonds. Long-term bonds are more sensitive to changes in interest rates than short-term bonds. The reason for this is that the longer the time to maturity, the longer the bond’s stated interest rate stays unchanged. In a falling interest rate environment, investors want to lock in a higher interest rate for a longer period of time, which boosts long-term bond prices. (In a rising interest rate environment, the opposite happens. Investors don’t want to be locked into long-term fixed interest rates, and place downward pressure on long-term bond prices.)
Direxion Monthly 10 Year Note Bull 2X fund (DXKLX) and Rydex Government Long Bond 1.2x Strategy fund (RYGBX) use leverage to increase their exposure to long-term bonds. DXKLX attempts to return double the performance of a 10-year Treasury bond index on a monthly basis. RYGBX uses leverage to magnify the daily return of the 30-year bond by 120%. Leverage can enhance returns during favorable market conditions, but also increases losses during periods of market turbulence. DXKLX and RYGBX ranked first and third among all mutual funds, with five-year annualized returns of 15.1% and 12.4%, respectively.
Wasatch-Hoisington U.S. Treasury fund (WHOSX) ranked second in terms of all overall performance, with a five-year annualized return of 12.8%. The fund holds principal-only Treasury STRIPS, which are very sensitive to changes in interest rates. A principal-only STRIPS, also known as a zero-coupon bond, does not receive regular interest rate payments. Rather, a single payment is received at maturity. These bonds are bought at a discount to their par value and appreciate in value as they move toward their maturity date. Since the rate of appreciation is tied to the bond’s yield, prices for such bonds can be very volatile. A falling interest rate environment favors STRIPS because they allow an investor to lock in a higher interest rate. (A rising interest rate environment hurts the prices of zero-coupon bonds.)
Wasatch-Hoisington U.S. Treasury fund’s objective allows its manager, Van Hoisington, to shift between short- and long-term bonds, depending on his outlook for the interest rate environment. Currently, the fund has an effective duration of 20.2 years, which is long. (Duration is a measure of a bond’s interest rate sensitivity.) Though the fund has done well over the past five years, its future performance will rely on Hoisington’s ability to properly react to any changes in bond market conditions.
|Gov’t: Long-Term Bond||11.3||0.94||3.9||19.9|
|General Bond: Long-Term||7.6||0.45||37.7||-7.4|
|Int’l Bond: Emerging||6.3||0.49||55.9||-18.6|
|Gov’t: Interm-Term Bond||6.2||0.21||9.7||10.6|
|General Bond: Interm-Term||5.9||0.21||25.7||-1.0|
|Corp High-Yield Bond||5.6||0.55||62.9||-20.5|
|Int’l Bond: General||5.5||0.43||30.4||-3.9|
|Muni Nat’l: Interm-Term||4.8||0.24||11.1||4.1|
|Muni Nat’l: Long-Term||4.5||0.29||14.1||-0.8|
|Gov’t: Short-Term Bond||3.6||0.09||5.3||6.7|
|Muni Nat’l: Short-Term||3.2||0.08||6.6||4.7|
|Target Date: 2000-2014||3.0||0.47||45.8||-24.9|
|General Bond: Short-Term||2.9||0.14||17.4||-4.4|
|Muni Nat’l: High-Yield||2.8||0.39||23.5||-15.4|
|Target Date: 2015-2029||1.4||0.76||69.5||-38.3|
|Int’l Bond: Currency||0.3||0.72||12.6||-5.5|
|Target Date: 2030+||0.2||1.02||91.7||-48.0|
|Real Estate Sector||-4.3||1.74||173.2||-66.3|
|*Bull market is defined as 3/1/2009 through 4/30/2011. Bear market is defined as 11/1/2007 through 2/28/2009.|
|Source: “The Individual Investor’s Guide to the Top Mutual Funds 2012,” February 2012 AAII Journal. Data from Morningstar Inc. is through 12/31/2011.|
Though the gold sector itself slipped in the overall rankings, two gold funds continued to hold onto their top-six overall ranking for five-year performance: Tocqueville Gold (TGLDX) and USAA Precious Metals & Minerals (USAGX). The two funds both realized five-year annualized returns of 11.9%, even after falling 15.9% and 19.7%, respectively, last year.
TGLDX holds physical gold in addition to its investments in gold mining companies. The precious metal accounted for 6.7% of the fund’s portfolio at the end of 2011, an increase over the 5.6% allocation held at the end of 2010. USAGX invests in precious metal mining companies, but the fund does not hold physical gold itself. Tocqueville Gold’s small allocation to gold helped the fund last year, as gold mining stocks fared worse than gold itself.
Though the gold sector ranks in the top 10 for five-year performance, it was the worst-performing mutual fund category last year, losing 22.9%. Not only are these funds influenced by metals prices, but valuations, stock market conditions, mining costs and reserves in the ground also play a role.
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.
Reynolds Blue Chip Growth (RBCGX) led all non-sector stock funds with a five-year annualized return of 11.2%. It also ranked in the top quartile of large-cap funds in 2008, 2009 and 2010. The fund lost 6.2% last year, however, trailing the large-cap category average.
Though the name implies large companies, the fund’s manager, Frederick L. Reynolds, considers companies with market capitalizations as small as $1 billion. This gives Reynolds the flexibility to oversee a very large portfolio—his fund held in excess of 1,000 stocks at the end of 2011. Allocations can shift, with Reynolds boosting the fund’s cash allocation in late 2007 and moving back into stocks in 2009.
Two Yacktman funds rank among the top performers, Yacktman Focused fund (YAFFX) and Yacktman fund (YACKX). These funds returned 9.1% and 8.0%, respectively, on an annualized basis over the last five years. Both also ranked in the top quartile last year for large-cap fund performance, returning 7.4% and 7.3%, respectively. (They were also top performers in 2008 and 2009.)
Whereas Reynolds is focused on growth, father and son co-managers Donald Yacktman and Stephen Yacktman and fellow co-manager Jason Subotky take a value-oriented approach. The Yacktmans also differ from Reynolds in their philosophy toward portfolio size, holding 54 securities in YACKX and 53 securities in YAFFX. (The average large-cap fund holds 210 securities.) Whereas too many securities can increase costs, too few securities can lead to increased volatility and larger losses if the fund managers make a mistake. The 10 largest holdings account for 53.6% of YACKX’s portfolio and 60.3% of YAFFX’s portfolio.
Table 2 shows the top funds over five years for each category. In addition to five-year performance, returns are displayed for each of the past 10 years and for the most recent bull and bear markets. Returns that are in the top 25% of all funds within the investment category are shown in boldface. Other pertinent information is presented, including yield, tax-cost ratio, risk, portfolio composition and expenses. Risk and expense numbers that are in the lowest 25% of all funds within the investment category are shown in boldface.
Five-year performance figures are very useful when evaluating fund managers because they balance consistency of performance with changing market and economic conditions. Any fund manager can get lucky over the course of a single year, but talent and a good strategy are required to outperform over a period of several years. A five-year period strikes a balance of offsetting the impact of a single year’s performance but not being so long that comparisons between funds become harder because of changes in managers and objectives.
Even though five years is a good time period for fund evaluation, an understanding of market and economic history adds context to the numbers. Solely building a portfolio by selecting funds from the categories with the best current five-year performance would result in a portfolio that has a significant allocation to bond funds. Though the future is always uncertain, it seems unlikely that bond funds will enjoy the same outperformance given the current low interest-rate environment.
Consistency of performance also matters. Wasatch-Hoisington U.S. Treasury fund topped the average long-term government bond fund by 9.4 percentage points last year, but underperformed its category average in 2007, 2009 and 2010. Conversely, Tocqueville Gold has given its shareholders a return above its category average during seven out of the past 10 years, including the last four consecutive years.
Be sure to take the extra step of looking at how long the current manager has been running the fund. For example, Henry Ellenbogen took over T. Rowe Price New Horizons fund (PRNHX) in March 2010. Though PRNHX ranked in the top quartile of all small-cap stock funds for the past two years, the fund’s performance prior to 2010 does not provide much insight as to how Ellenbogen will perform in the future. (The online version of this article, available at AAII.com, shows when the current manager for each fund started.)
You should also consider how much risk a fund’s strategy incurs. Funds that use leverage, such as Rydex Government Long Bond 1.2x Strategy fund, will be more volatile than their non-leveraged category peers. Risk is also relative to the category in which a fund operates. Vanguard Emerging Market Index fund’s (VEIEX) total risk index of 1.59 may seem high when compared to other stock funds, but the fund incurs less risk than the average emerging market fund.
Lower expenses are always preferable, though—as is the case with performance—costs are relative. A mid-cap domestic stock fund is cheaper to operate than a global stock fund. As a result, the 0.81% expense ratio for mid-cap stock fund Meridian Growth (MERDX) is not comparable to the 1.15% expense ratio for global stock fund Old Westbury Global Small & Mid Cap (OWSMX).
In addition to the expense ratio, a maximum load may be listed. A load is a fee charged for buying (front-end load) or selling (back-end load or redemption fee) a fund. These fees are often reduced or waived if the fund is held for a certain period of time or if a certain amount is invested. For example, the two Yacktman funds charge a 2% back-end load if shares are redeemed within 30 days of purchase. Terms vary by fund, so read the mutual fund’s prospectus for specific information about the load and other charges.
If a mutual fund is held in a taxable account, the tax-cost ratio should be considered. Since mutual funds are comprised of pooled investment dollars, net capital gains are passed onto shareholders of record at the time the fund sells the security. Shareholders must pay taxes on these gains, regardless of whether they sold shares of the mutual fund itself or not, and regardless of how long they have owned the mutual fund.
Portfolio turnover plays a role in both expenses and tax costs, with higher levels indicative of more active trading by the fund manager. Investors seeking lower costs and/or less tax exposure may want to opt for funds with lower portfolio turnover ratios.
If costs or tax efficiency are among the key characteristics you examine when looking at mutual funds, consider an index fund. Since they don’t rely on the skills of an active manager, their costs tend to be lower. Some actively managed funds do a good job of controlling costs, however. Fidelity Small Cap Discovery fund (FSCRX) has a tax-cost ratio below the average for small-cap stock funds, and it kept its portfolio turnover to just 11% last year.
Before investing in any fund, read the prospectus. Have a clear understanding of the fund’s objective, strategy, risks and cost structure.
Next, obtain the latest fund report and review the holdings. What securities are currently being held in the fund? How much of the portfolio is concentrated in each of the key holdings? If the fund manager provides commentary, read it to get additional insight into his thought process.
Finally, remember that even though mutual funds are intended to be long-term investments, you should never buy and then forget about them. Like any investment, mutual funds should be periodically monitored to make sure the objective has not changed and the fund is performing as expected given prevailing market conditions and historical performance.
Pay attention not only to current performance, but also to current performance relative to historical performance and relative to the fund’s category average. A mutual fund that lags in market conditions that it historically has done well in should receive more scrutiny than a mutual fund that is following its historical volatility trends and is producing returns that are similar to those of its peers.