Fool.com: On Picking Mutual Funds [Fribble] May 24, 2000

Fribble On Picking Mutual Funds

By Tim Thurman (TMF DrT@aol.com)
May 24, 2000

So you're a new reader who has always heard how good it is to invest in mutual funds, and then these motley-dressed and irreverent Fools say that funds are not as good as you thought, since three or four out of five (depending on the time period you look at) can't keep pace with the market. Well, why not just invest in those that can beat or at least keep pace with the market? Isn't that the obvious trick? Yes, it certainly is. A trick, that is.

It seemed pretty logical to me when I was in that position about four years ago, so I got a copy of Kiplinger's annual rag, Mutual Funds '96, and started looking. I had read elsewhere an article on the Kaufmann Fund with interviews of these two Wise men of Wall Street, Lawrence Auriana and Hans Utsch; and I had discussed with my broker the phenomenal success of Garrett Van Wagoner, who had just had the top-performing fund in the world two years in a row! He was clearly going to be in that select group, and it seemed likely that the Kaufmann Fund would be, too. Reading in Kiplinger's and looking at the charts of the "best funds" in various categories seemed to confirm my feeling. I also discovered Pilgrim Baxter Funds in Kiplinger's. I liked them well enough to get into two of their funds.

So I had bought into four funds that seemed to me to be likely candidates for those funds that would outperform the market. After all, according my research, they had already been doing so. I had found some of the winners.

Wrong again, Tall Tim. Three years later these four stellar funds had a combined average return of -9.5%! That's right, I had lost money over those three years in these outstanding funds, managed by truly bright, hard-working, and well-respected members of the mutual fund managers class. The only one that was positive was the Kaufmann Fund, which was up a whopping 11%. "Hey, that's the market average!" you quickly point out. Whoops. That's the market's annual average. This was over a three-year period, meaning that the fund had really done closer to 3% per year. And how had the market actually done in these years? Uh, if you don't know how the market performed over the last five years of the last century, you haven't been paying attention. We'll call it around 25% per year during that time. (That's only a rough figure, but it puts things in accurate perspective.)

Someone might point out that these were all small- and mid-cap funds (growth and emerging growth), areas that had a particularly bad performance during these years, so my figures were atypical, unfair, and useless. In fact, it only underscores my main point, namely, that you can't know which funds are going to do well in the future. Just as no one was predicting how poorly small- and mid-cap stocks would perform during the last five years.

I sold all these funds, having learned the hard lesson of why this idea won't work. It's because, dear Fool, there's no way of knowing which funds are going to continue to perform as they have in the past. In fact, it appears that a mutual fund is at least as likely not to do as well in the future as the past, simply because as they grow bigger and more profitable, it becomes more and more difficult for them juggle the growing number of stocks they hold.

Predicting how a mutual fund is going to perform in the future is not the same thing as predicting how a stock, that is, a company and its business, is going to perform. Management of a profit-making business enterprise is not the same thing as managing a mutual fund. They may be the same kind of animal (beasts of prey), but they can be as different as hawks and hyenas. Several years of continued earnings growth has some predictive power when researching a stock; several years of outstanding returns has almost no predictive power when looking at a mutual fund. Just ask Garrett Van Wagoner.