In mutual fund investing there are no immutable laws to guide us, as we have in physics. But the collective experience of fund investors can be distilled into a few general rules. Some of it has empirical evidence pointing its way. Most is simply common sense that investors often set aside or forget in the heat of making an investment decision.
Top performance lists are dangerous. Probably the single most potentially dangerous action a mutual fund investor can take is to glance at these ubiquitous lists. Funds make the top of the lists not because they are like all the rest of the funds, but because they are decidedly different in some important way. Risk is usually the first important difference. For stock funds, holding stocks that are more volatile than the average stock, holding fewer stocks, or concentrating on only a few industries, raises risk and puts a fund in position to have a greater chance at making the top of the list.
As an example, take sector funds. You can't beat the market by holding it, which is why you can always find a sector fund of one kind or another at the top of most performance lists. Call it stock picking, or industry weighting, or both, but the net effect is increased risk, and less diversification than the overall stock market.
Picking the funds at the top of the performance lists assumes that either these same stocks or sectors will continue to do well, or that the managers can continue to deftly take high risk and move money around better than all the rest.
For domestic bond funds, making the top of the list is a result of the maturity structure of the fund's portfolio. The longest maturity bond funds will be at the top of the performance lists when interest rates are falling, and at the bottom of the lists when interest rates rise. So, investing in bond funds that are at the top of the list is a forecast of interest rates—that they will stay constant or continue in the same direction, a prediction that even professional interest rate prognosticators have been woefully unsuccessful in getting right.
However, these top/bottom lists may hold a small glimmer of value. There is some empirical evidence that stock funds at the top of the heap one period have a greater likelihood to have this superior performance in the next period, on average—"hot hands" may stay hot. Why might a fund's superior performance persist? Probably because the stocks/sectors emphasized in the portfolio continue to have positive momentum into the next period. The shorter the time periods observed, the more likely this is to be true: quarter-to-quarter performance persistence is more likely than year-to-year. But be careful, this is based on performances of top funds on average, and investors don't invest in fund averages, but instead invest in individual funds.
What is more telling, however, is that bad funds tend to continue to be bad. But again, be careful. If an entire category of funds—small stock value funds or emerging market funds, for example—do poorly, then making the bottom list is probably meaningless if your fund has a lot of peer companions. But if large stock growth funds populate the top list or simply are not to be found in numbers on the bottom list, and your large stock growth fund makes an appearance at the bottom of the pile, it isn't a good sign.
And, of course, being a knee-jerk contrarian and buying funds that make the bottom list on the theory that what falls must rise, is probably a seriously flawed approach to fund selection.
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