What does “Best” really mean?

Written by John Osbon on May 21, 2013

If you had to predict which players would top the money list in golf or tennis next year, you’d probably give strong consideration to this year’s top money winners. Same goes for top home run hitters and pitchers in baseball. Ditto for top-selling car brands and most-watched TV shows.

It’s natural to expect that last year’s winners will continue to do well. Watching LeBron James dominate the court this year, we expect him to do so next year too. And he probably will.

Many expect similar performance patterns in the investment world. Unfortunately investing is not nearly so predictable.

Walking randomly

We saw this a couple weeks ago when we looked at the track record of major asset classes over the last five years. What we found was a seemingly random pattern where gold led the pack for two years, then went straight to the back of the bus.  Emerging markets did just the opposite a few years earlier, moving from worst to first in one big leap. The rankings of other asset classes jumped around in a pattern that could only be called random.

Anyone picking asset classes based on what did well in the previous year would be in for lots of frustration.

It turns out that it’s just as tough to predict performance of individual mutual funds using past performance as a guide.

At the end of 2011, Bloomberg assembled a list of 10 top performing actively managed mutual funds for 2011 – the funds that produced the greatest return for the year. In a generally flat market that year, the top 10 averaged almost a 10 percent return for the year.

Did outperformance continue?

In a burst of curiosity, we checked to see how well those funds performed in 2012 and beyond. Did the good return in 2011 lead to more of the same in later periods?

Well, yes and no. In the past year (ended May 15, 2013), the average return of those ten funds jumped up to nearly 24 percent. That is a nice increase. But it’s a significant shortfall to the S&P 500 index, which produced 28 percent.

Furthermore, these so-called ten top funds fell far short of the ten funds that Bloomberg listed as the worst of 2011. In the past year, these prior weaklings generated a nearly 30 percent return.

Wait, what was that again? If you read about the top funds of 2011 and bought them a year ago, in May 2012, you would have not only earned less than the S&P 500 in the past year, but also significantly less than the ten funds that Bloomberg ranked as the worst of 2011. It makes you wonder.

Ignore the rankings

It’s numbers like these that make us so content to own indexes for the long term instead of trying to predict next year’s big winner. Not to mention that all of the funds in both of Bloomberg’s best and worst categories have expense ratios far higher than the typical index ETF. And some charge front-end loads of more than five percent. That’s a nifty “sales fee” paid for the privilege of buying a fund, even if it ranks in the bottom one percent of performance.

We encourage all investors to ignore lists of bests and worsts, star ratings, manager rankings and all other historical data. There’s just no reason to expect they’ll lead you better performance than you’ll experience with low expense, tax-efficient index investments.


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