While health care mutual funds had a rough 2016 compared to other category averages, they still remain the top-performing category over the last five years.

Health care funds retained four of the 10 top positions in the updated Top Funds Over Five Years list, but lost some ground compared to last year’s list when the seven of the 10 top were health care funds.

Consumer discretionary funds remain the second-best category over the last five years, while the financial and industrials sectors pushed their way up to third and fourth, up from seventh and tenth place, respectively.

Financial and industrials funds began picking up steam in the third quarter of 2016. They ended the year as the two best-performing sector categories for the fourth quarter, with financial funds gaining 16.1% and industrials funds gaining 9.4% on average. The financial sector has benefited from increasing interest rates (and the expectation of more increases on the horizon), and both sectors have benefited from the election of Donald Trump as president due to his campaign promises of decreased regulation and increased infrastructure spending.

Although precious metals and energy were the two top-performing fund categories during 2016, it wasn’t enough to remove them from among the worst-performing categories over the last five years. Many precious metals and energy sector funds significantly underperformed during 2014 and 2015.

Equity funds have outperformed bond funds over the last five years, on average, which is generally the case during a bull market. This is a significant change compared to 2012, when the five-year period included a market crash and the top eight best-performing categories were bond fund categories. When the 2012 Top Funds Over Five Years article was written, the five-year annualized return covered the years 2007, 2008, 2009, 2010 and 2011.

The only category that had a double-digit five-year annualized return in 2012 was long-term government bonds, with an 11.3% gain. The runner-up was long-term general bonds, with an average gain of 7.6%. Over the last five years (2012–2016), these categories have returned 1.8% and 4.7%, respectively.

The switch in top-performing categories from bond to stock over the last five years is a reminder that different categories perform well depending on the state of the economy, market expectations, inflation, etc. Maintaining a diversified portfolio, as opposed to chasing return, is in your best interest.

Returning Top Funds

Last year PRIMECAP Odyssey Aggressive Growth (POAGX) was the only non-sector fund to make it onto the top 10 overall list, and it held its ground this year. PRIMECAP Odyssey Aggressive Growth invests in primarily small and mid-cap stocks and uses a bottom-up approach to find companies with prospects for rapid earnings growth. The fund is closed to new investors.

Table 1. Five-Year Returns for Category Averages

Among large-cap funds, USAA NASDAQ-100 Index (USNQX) is the only holdover from last year’s top-performing list. Parnassus Endeavor Investor (PARWX), which took over the best-performing large-cap fund title, is new to the list. Parnassus Endeavor has outperformed its category from 2014 to 2016 and has a category risk index of 1.0 (meaning that the volatility of its returns is in line with the category average). The fund is unique in that it normally invests at least 80% of its net assets (plus borrowings for investment purposes) in companies believed by the fund’s investment adviser to provide good workplaces for their employees. Thirty-six percent of the portfolio is invested in the technology sector, while 30% is invested in the health care sector. [See “The Next Generation of Socially Responsible Investing” for more on environmental, social and governance (ESG) funds.]

Two of the top-performing mid-cap funds this year also appeared on the top five-year list last year: the aforementioned PRIMECAP Odyssey Aggressive Growth (POAGX) and Vanguard Strategic Equity Investor (VSEQX).

New to the mid-cap list this year is Ariel Fund Investor (ARGFX). Lead manager John Rogers and his team focus on value-oriented stocks with strong balance sheets. The fund is slightly concentrated with only 39 holdings, but the portfolio’s turnover is 20%, significantly lower than the mid-cap stock category average of 75%. This low level of turnover may explain why the fund is also one of the most tax-efficient in this year’s ranking.

New to the Top 10 List

Six of the top 10 performing funds over the last five years are holdovers from last year’s list: Fidelity Select Biotechnology (FBIOX), Fidelity Select Retailing (FSRPX), Janus Global Life Sciences T (JAGLX), PRIMECAP Odyssey Aggressive Growth (POAGX), T. Rowe Price Global Technology (PRGTX) and T. Rowe Price Health Sciences (PRHSX).

The four newcomers to the top 10 list are Fidelity Select Air Transportation (FSAIX), Fidelity Select Semiconductors (FSELX), Hodges Retail (HDPMX) and Rydex Biotechnology (RYOIX).

Fidelity Select Semiconductors (formerly called Fidelity Select Electronics) invests primarily in domestic large-cap stocks; however, 14.0% of the portfolio is in foreign stocks, while 21% of the portfolio is allocated to mid-cap stocks. During its most recent fiscal year, the fund’s turnover rate was 179%, above the technology category average of 145%. The fund’s percentage of its portfolio in the top 10 holdings is 67%, indicating that its performance is heavily dependent on its largest holdings.

Fidelity Select Air Transportation (FASIX) outperformed its category average during 2013, 2014 and 2016, but lagged in 2015. Its holdings are primarily large and mid-cap stocks. While the fund has performed well on an annualized basis over the last five years, its portfolio is a concentrated segment of the industrials sector (companies engaged in the regional, national and international movement of passengers, mail, and freight via aircraft). Fund manager Matt Moulis, who started managing the fund in 2012, centers his focus on value—particularly metrics like expected profit growth, return on capital, and conversion of free cash flow—as well as company-specific risk.

Rydex Biotechnology (RYOIX) targets biotechnology stocks. Though classified as having a mid-cap growth style, its five largest holdings, which represent 27% of the total portfolio, are Amgen Inc. (AMGN), AbbVie Inc. (ABBV), Celgene Corp. (CELG), Gilead Sciences Inc. (GILD) and Biogen Inc. (BIIB). The fund’s total risk index of 2.54 is much higher than the health care sector average of 1.67, but the fund outperformed its category average during the last bear market, losing 26.4% compared to the health care category average loss of 35.6%.

Hodges Retail (HDPMX) invests primarily in micro- and small-cap domestic stocks, but also has the ability to invest in large-cap stocks if its managers choose to. The fund targets companies whose shares are out of favor, but appear to have prospects for above-average growth and recovery over an extended period of time. Hodges Retail is most heavily weighted in the consumer cyclical and basic materials sectors. Over the last five years, Hodges Retail outperformed its category average (small-cap stock) in 2013, 2014 and 2016.

My Fund Underperformed, Now What?

Just because your mutual fund holdings didn’t make the top 10 list doesn’t mean that you should turn around and sell them.

Diversification is an important concept to mutual fund investing and investing in general. If you held all the funds that made the top of the list this year you would overweight health care, which isn’t prudent.

Bond funds offer diversification benefits even though they are unlikely to have the blockbuster returns in any given year. This is commonly known as the risk/return trade-off. For example, the long-term general bond category average total risk is 0.51, significantly lower than the health care sector category average total risk of 1.67. Risk can magnify returns to the upside or downside.

In this situation, compare the top funds in a particular category to a specific fund you are monitoring. If your mutual fund holding is constantly underperforming other funds in the same category over a period of years, a change may be warranted.

Additionally, aside from five-year performance, other fund statistics and figures should play a role in the selection process for your portfolio, as I explain later.

Don’t chase performance: Choose funds that fit into your desired asset allocation and investment strategy, and remove funds that continually underperform their category.

Fund Listings

Table 2 shows the overall top 10 funds for the five-year period, as well as the top five-year funds 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 presented includes tax-cost ratio, yield, 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.

Leveraged Funds Excluded

Ultra, contra and similar leveraged funds are excluded from the top fund listings here. Though funds such as Rydex Dynamic NASDAQ-100 2X Strategy (RYVYX) and ProFunds Ultra NASDAQ-100 (UOPIX) have impressive five-year annualized returns (both up 30.0%), they also plunged by 80% during the last bear market.

While such funds can be good trading vehicles when you correctly guess the future direction of the market, they also significantly penalize you for being wrong. Furthermore, their inclusion would have knocked out several funds that don’t use leverage, have greater widespread appeal and are more suitable for many investors. A list of the best-performing funds over the last five years that includes the leveraged funds is available here.

Look Beyond Performance

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 without being so long that comparisons between funds become harder because of changes in managers and objectives.

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 is heavily skewed toward domestic sector funds, particularly health care. Sector funds are dependent on the trends of the industries they track and tend to overweight the largest 10% of their holdings. Small-cap funds tend to incur more return volatility, as evidenced by the total risk index score of 1.84 for Hodges Retail.

Consistency of performance matters. Parnassus Endeavor Investor has ranked among the top 25% large-cap funds in 2012, 2014, 2015 and 2016. In contrast, while Parnassus (PARNX) also made it to the five-year top-performing list, it was not a top 25% fund in its category in 2013, 2015 and 2016.

Be sure to take the extra step of looking at how long the current manager has been running the fund. For example, Ziad Bakri took over as manager of T. Rowe Price Health Sciences last April. Though the fund itself has fared well, on average, over the last five years, there is no track record to reveal how Bakri will perform as a manager. (The spreadsheet shows when the current manager for each fund started.) Several Fidelity funds listed in this article have managers with short tenures.

As previously stated, you should also consider how much risk a fund’s strategy incurs. Fidelity Intermediate Bond Index Investor’s (FIBIX) category risk index score of 1.52 is almost double that of the government intermediate-term bond category peer Fidelity Government Income (FGOVX), which has a risk score of 0.97. This big difference in risk exists even though the two funds’ five-year returns are equal at 1.3%.

Risk is also relative to the category in which a fund operates. Fairholme Focused Income’s (FOCIX) total risk index score of 1.24 may not seem very high, but the fund’s category risk index of 2.48 shows that it incurs over double the risk of the average corporate high-yield bond fund.

Costs Matter

Lower expenses are always preferable, though—as is the case with performance—costs are relative. A domestic fund is cheaper to operate than a fund that targets foreign investments. For example, the 0.45% expense ratio for the large-cap fund Vanguard Cap Opportunity Investor (VHCOX) is not comparable to the 1.60% expense ratio for foreign stock fund Oberweis International Opportunity (OBIOX).

In addition to the expense ratio, a maximum load may be listed in Table 2. 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 dollar amount is invested. For example, Fidelity charges a 0.75% redemption fee on shares held less than 30 days for several of its sector funds, including its top-performing semiconductor and air transportation funds. Terms can vary by fund, so read the mutual fund’s prospectus for specific fee information.

If a mutual fund is held in a taxable account, the tax-cost ratio should be considered. Since mutual funds are composed of pooled investment dollars, net capital gains are passed on to shareholders of record at the time the fund sells the security. Shareholders must pay taxes on these capital gains, regardless of whether or not they sold any shares of the mutual fund itself 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 mutual fund characteristics you examine, 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. For example, PRIMECAP Odyssey Aggressive Growth fund’s turnover ratio is 15.0% and its tax-cost ratio is 1.0%, whereas mid-cap stock funds have an average turnover ratio of 75.0% and an average tax-cost ratio of 1.5%.

Further Evaluation

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.

Finally, remember that even though funds are intended to be long-term investments, you should never buy and then forget about them. 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 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 similar to those of its peers.

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