Why Mutual Fund Rankings Are Pretty Much Useless

(MoneyWatch)  At the end of every quarter, the financial press engages in its mutual fund ranking ritual. Don't get caught up in these rankings, because they have little to no predictive power.

Anyone who's spent time following mutual funds knows that yesterday's winner may well be tomorrow's loser.

One good example is a guy you may have hear of -- Bill Miller. He is the manager of the Legg Mason Value Trust, and prior to this year was quite a media favorite.

To his credit, he had a good stretch of beating the S&P 500, and he happily advertised his market beating prowess. If you invested with him during those years, great. But I hope you didn't have much money with him last year.

His fund was hammered in 2008, falling 55 percent, and then tanked another 20 percent in the first part of 2009. Investors who jumped on the Value Trust band wagon after reading about its high ranking are now licking their wounds. And by the way, I don't remember any media outlets warning of the impending collapse of Miller's performance record.

You see, that's the problem with rankings. They're backward looking, and as you know, past performance is not indicative of future returns. What you need to understand is that for mutual fund managers to beat the market, they have to take more risk. Usually, their high risk taking catches up to them, and the market extacts its wrath.

Unfortunately, it's mutual fund investors who bear the losses. When the bottom falls out, the manager walks away, while investors are left to ponder their decimated retirement plans.

So don't spend much time reading about this quarter's winners in the mutual fund industry. The only real value the rankings provide is from an expense standpoint. Generally, all else being equal, lower cost funds provide investors with better long term returns. It is simple math.

Oh, I guess the rankings also serve as a good reminder that most mutual funds don't beat the market.

Bottom line: To protect your retirement money from an aggressive manager's ill-timed bets, consider sticking with low cost, well diversified funds that are basically attempting to track the broad stock or bond markets. Index funds are of course another good option.

It is interesting that those who try to beat the market usually end up getting severely beaten by the market.

As with any financial decision, please consult your individual advisor before making any investment decisions.

Stock market photo courtesy of rednuht, C.C. 2.0