Let's say some fund manager has a fabulous quarter — or even a year or two — ripping up the market with his little growth-stock fund. Suddenly, the manager's mug is plastered across various financial magazines and Web sites, he or she is hailed as the next investing genius, and then hundreds of millions or even billions of new investor dollars come pouring into the fund.
Short-term (one year is a short time period) fund performance numbers don't mean much — luck can be just as big a factor as skill. Also remember that earning much higher returns than other similar funds often means that the manager took a lot of risk. The greater the short-term returns for that fund and manager, the greater the odds of a sharp slump.
The history of short-term mutual fund star funds confirms this: Of the No. 1 top-performing stock and bond funds in each of the past 20 years, a whopping 80 percent of them subsequently performed worse than the average fund in their peer group during the next five to 10 years. Some of these former No. 1 funds actually went on to become the worst-performing funds in their particular category.
Although a fund's performance, or its historic rate of return, is certainly an important factor to weigh when selecting a mutual fund, investors tend to overemphasize its importance. Choosing funds on simplistic comparisons of performance numbers is dangerous.
As all mutual fund materials are required to state, past performance is no guarantee of future results. Realize that funds with relatively high returns may achieve their results by taking on a lot of risk. Those same funds often take the hardest fall during major market declines.
Remember that risk and return go hand in hand; you can't afford to look at return independent of the risk it took to get there. Before you invest in a fund, make sure you're comfortable with the level of risk the fund is taking on.
Consider this case of an overhyped mutual fund: Launched in 1991, Fidelity Growth Strategies invests in medium- sized growth companies. The fund performed a little better than the market averages in the early to mid 1990s, and then it dramatically outperformed its peer group in the late 1990s.
So, Fidelity promoted the heck out of the fund, and investors piled in — to the tune of nearly $10 billion in new investments in 1999. And Fidelity had some help from articles like the one that ran in the July 18, 1999, issue of the New York Times.
In a positively glowing profile of the fund and its manager, Erin Sullivan, the Times called Sullivan "the quintessential portfolio manager." And it added in the following material, which caused investors to send Sullivan's fund their investment dollars:
"Ms. Sullivan, 29, has been in charge of the $5.96 billion Fidelity Aggressive Growth fund since April 1997. In that time, the fund has posted total returns of 51.83 percent, annualized, vs. 33.16 percent for the Standard & Poor's 500-stock index. … This year through July 15, the fund was up 44.34 percent, nearly tripling the 15.4 percent gain of the S&P 500.
"Ms. Sullivan goes about her business with the self-assurance of a Harvard graduate, the analytical rigor of a math theoretician and the vigor of a marathon runner, all of which she is. But she has not entered a marathon race roughly since she took the reins of Aggressive Growth. 'It's hard to find time for anything else,' she said."
Within months of the Times article, the fund's fortunes changed. Overloaded with overpriced technology stocks, the fund plunged 84 percent in value from early 2000 to late 2002.
And it was one of the worst-performing funds of the decade just ended, with an annualized average return of -9.9 percent.