Bad Fund Picking Advice from Barron's

(MoneyWatch)  There was an interesting article on the Barron's website this past week. In it, Randall Forsyth wrote that after examining the most recent three-, five-, and ten-year returns for the 40 largest mutual funds, "one is struck in finding [that] so few underperformed [the Vanguard 500 Index Fund.]"

Forsyth goes on to conclude that mutual fund investors have, as a group, demonstrated a remarkable ability to pick winning funds because "[t]he data show that they have made the funds with the best long-term performance the biggest sellers."

Hmmm. The funds with the best performance are the biggest sellers. Interesting. In grade school we had a word for such an observation: Duh!

In other news, the horse with the fastest time won the Kentucky Derby and the golfer with the lowest score won the Masters.

Of course most investor money flows to funds with the best long-term performance. Past performance is the main criteria that most investors use in selecting their mutual funds, and they aren't choosing the losers. They're picking the winners, of course, in the hopes that performance will persist.

In other words, these funds are big in large part because of their stellar past returns.

Forsyth's analysis implies that to find tomorrow's winning funds we need merely choose one of today's largest funds. So let's take a look and see how such a strategy would have fared in the recent past.

To do that, of course, we need to examine not the records of today's largest funds, but the records of yesterday's largest.

Like Forsyth, we'll use Lipper data and look at trailing three-, five-, and ten-year periods. But instead of focusing on the returns over those periods of today's largest funds, we'll look at the performance of the 40 largest funds at the start of each of those time periods. That, after all, is how an investor today is making their selection using Forsyth's strategy.

The first table below shows the relative performance of the 40 largest funds at the end of each time period. As you can see, they performed quite well, with the majority of the top 40 outperforming the Dow Jones Total Market Index. So far, Forsyth's theory holds; the largest funds at the end of each period, as a group, are indeed above-average performers.

3 Years
% of Funds Outperforming Market: 2003 - 2006
2006's 40 Largest Funds	60%

5 Years
% of Funds Outperforming Market: 1999 - 2004
2004's 40 Largest Funds	75%

10 Years
% of Funds Outperforming Market: 1989 - 1999
1999's 40 Largest Funds	51%

But now for the real test. We need to see how those same funds performed in the subsequent periods.

3 Years: % of Funds Outperforming Market
	2003 - 2006	2006 - 2009	Change
2006's 40 Largest Funds	60%	45%	-15%

5 Years: % of Funds Outperforming Market
	1999 - 2004	2004 - 2009	Change
2004's 40 Largest Funds	75%	42%	-33%

10 Years: % of Funds Outperforming Market
	1989 - 1999	1999 - 2009	Change
1999's 40 Largest Funds	51%	47%	-4%

Quite a contrast. The relative performance of the largest funds in these periods declined by an average of 17 percent from the first period to the second, leaving our investor, in each case, with a less-than-50/50 chance of outperforming the market. And don't be fooled by that apparently narrow spread in the ten-year table. Lipper data are survivor-biased, which means that they include only funds that actually survived the entire 20 year period, and not the records of any funds that disappeared. I can assure you that in 1999 there were quite a few technology-heavy mutual funds in the top 40 that failed to survive the subsequent ten years. Including these funds would both increase the outperformance in the first period, and lower it in the second.

So to reiterate, of course today's largest funds are dominated by yesterday's winners. That fact merely reaffirms the notion that investors fall in love with past performance. But what the data above also reaffirm is that relying on yesterday's winners to continue their winning ways is a fool's errand.

In an industry notorious for its lack of guarantees, let me close by offering you one that's rock-solid: Somewhere in the list of today's equity funds, well outside the 40 or 50 largest, is a currently-tiny fund that will provide wonderful returns over the coming decade, far outpacing the market index. Its performance will attract both attention and assets, and in 2019 it will be counted among the industry's largest funds. At that point, even more investors will take note of its wonderful track record, and pat themselves on the back as they hop aboard a winner.

You can spend your time culling through mutual funds in search of that fund, or you can choose an all-market index fund, taking comfort in both the tremendous amount of free time you've created for yourself, and the knowledge that by the time 2029 rolls around, the odds are overwhelming that the intermediate-term winner you've passed up will have proved to be yet another comet that's fallen to earth.