Bad Fund Picking Advice from Barron's

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.

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.