Investment Consult

Bet on the ball that rolls, not on the one that bounces

Volatile funds provide exciting ups and downs, but more consistent portfolios are likely to deliver a bigger thrill: topnotch long-term returns.

By Lewis J. Altfest, PhD, CFA, CFP

The best in the business—whether they're athletes, CEOs, attorneys, or musicians—are successful because they perform at a high level year after year, no matter what's demanded of them. The same holds true for mutual fund managers.

In most cases, you'll do best with a diversified stock fund that finished in the top quartile within its investment category for five straight years. That's a better choice than one that performed unevenly over the same period—even if the latter fund delivered a somewhat higher average annualized return. Why? Because in the long run, the more consistent fund will be more predictable, I've found, and therefore more likely to excel. You can be more certain that the manager won't place any wild bets that may blow up and seriously erode your returns.

Yes, there are exceptions to this rule. Some managers of extremely volatile funds, including certain sector funds, deliver superior long-term returns. If you're comfortable with risk—particularly if you're young and won't need to cash out anytime soon—it's okay to make such funds part of your portfolio. Just be sure to base your purchase on more than a spectacular one-year record, or even good five-year numbers.

Let's examine that stellar single year first. A couple of things could explain it. First, perhaps the prices of a handful of stocks shot up because other companies acquired them. Unless the manager's a wizard at spotting takeover targets, you're not likely to get this sort of lucky bounce again. Second, one hot sector of the market may have been overweighted in the portfolio. Maybe the manager was brilliant and picked the right sector, or perhaps he got lucky. A typical investor might never know, but an experienced money manager can usually tell. Many times, I've found, a chart-busting annual return is the result of luck.

Good five-year returns, of course, are seldom a matter of chance. But volatile funds with strong five-year records often face a problem that consistent, less-flashy ones don't: They attract a slew of eager investors and their assets grow quickly, making it increasingly difficult for their managers to find enough good stocks to buy. The problem is especially pronounced among small-cap funds; their managers may be forced to buy larger companies that they're unfamiliar with. The pile of new money becomes an albatross.

Now consider funds that demonstrate consistent performance. Among those that I recommend are Mairs & Power Growth (800-304-7404), Selected American Shares (800-243-1575), and Royce Total Return (800-221-4268), which on a five-year average annualized basis have returned 18.2, 20.8, and 15.3 percent, respectively. These no-loads have proven that their records aren't the fluky result of one spectacular year and four mediocre ones. Instead, the portfolio managers successfully adjusted their buying and selling strategies to reflect varying market conditions, and they were able to recognize and avoid overvalued stocks and sectors.

To put this in perspective, look at a diversified stock fund's return in 2000, a year of retribution for tech-heavy funds. If the return was good, chances are the manager didn't overweight technology. He probably invested against the herd and spread the fund's assets around, taking care not to get too heavily focused in one area of the market. Don't get me wrong: It's okay to emphasize one sector slightly. But when one makes up half or more of a nonsector fund's portfolio, the manager is shooting craps with your money.

How can you determine whether a fund overemphasizes a sector? Refer to Morningstar Mutual Funds, which many public and college libraries carry. You'll find the sector breakdown in the lower right-hand corner of each fund page. This information is also available on Morningstar's Web site (www.morningstar.com) at no charge. On the site's opening page, enter the name of the fund or its ticker symbol, then scroll down to the section labeled, "What does this fund own?" Next, click on "View complete asset breakdown."

More important, Morningstar provides measures that show at a glance whether a fund is performing consistently. In the print edition, look at the top of the page for the series of boxes marked "Performance Quartile." These boxes depict which quartile the fund finished in, within its Morningstar category, for each year considered. Weed out any funds that didn't score in either of the top two quartiles in at least four of the past five years. Every fund is entitled to finish in the bottom half of its category once, but if it happened in the most recent year, this could indicate a change in management or investment approach. Either change could put the fund at a disadvantage against its peers.

To find out where a fund ranks within its category on a cumulative five-year basis, look at the section labeled "Trailing," under the "Performance" heading, and check the figure identified as "% Rank—Cat." The lower the number, the higher the fund ranked in its category. To find this figure on the Web site, click on "Trailing Returns" (below "Total Returns," on the left side of the screen).

I recommend only no-load funds that rank in the top 25 percent on a cumulative five-year basis. But, again, check the yearly performance quartile boxes to make sure that the fund's record is consistent.

The author, a fee-only financial planner, is president of L.J. Altfest & Co.( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

 

Lewis Altfest. Investment Consult: Bet on the ball that rolls, not on the one that bounces. Medical Economics 2001;6:34.