Why We Think It's So Easy to Find a Top Performing Mutual Fund

Last Updated Oct 22, 2009 3:26 PM EDT

On any given day, you can open a newspaper or surf financial web sites, and you'll see an advertisement for a top performing mutual fund. You can be sure it will have a disclosure stating that past performance is not indicative of future performance, just as you can be sure that we will ignore the disclosure. After all, it sports a Morningstar four or five star rating out of its five star maximum, so wouldn't it be the rational thing to rush out and buy it? Actually, not so much.

To begin with, Morningstar assures me that there are as many one star mutual funds out there to buy as those with five stars. There are also an equal number of two star funds as four star funds. Yet have you ever seen an advertisement for a one star fund? I'm guessing not. Furthermore, Morningstar itself advises that picking five star funds is not a good way to build a portfolio.

Let's just say I decide to start my own expensive mutual fund family with high expenses. Because I'm backed by Wall Street, I come out with 100 different equity funds. My high fees translate to an average Morningstar rating of 2.0. But with so many funds, the law of large numbers gives me a few outliers including one fund, say the Allan Roth Gold Leveraged Fund, that got very lucky and earned the five star rating.

Well guess which fund I advertise? My five star fund, of course. Naturally, I attract quite a bit of investor money just in time for this fund to crash and burn.

My advice
What you are seeing advertised is anything but a representative sample of a mutual fund family's performance. Morningstar lists overall family performance and I'd put the family's rating before that of the individual fund rating. Look at the cost of the fund and make sure the expense ratio is well under 0.5 percent annually. I rarely invest in anything over 0.3 percent annually. Any fund with a letter in front of it indicates that it comes with a hefty sales load on top of the fee. My advice is to avoid those like the Emergency Room in flu season.

So the next time you see an ad for the hot performer, keep in mind the fund that you won't see advertised. If you were, it might look something like this.

Note: Graphic from "How a Second Grader Beats Wall Street"

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.