Why You Shouldn't Buy Top-Performing Investments

When it comes to selecting mutual funds, most investors use one overriding criterion to make their picks: past performance. After all, if a fund has done well in the past, isn't that a good indicator that it will continue to do well in the future?

That's why you see investors piling into funds and asset classes after they have racked up category-topping returns. Unfortunately, investors who follow a performance-chasing pattern like this are usually moving into investments at exactly the wrong time. Because history has shown us that even the best managers tend to stumble -- and stumble pretty hard, in some cases.

Falling on hard times
As a prime example, we can point to three famed stockpickers whose funds once ranked at the very top of their peer groups. Now, these funds have fallen to the bottom of the charts so far in 2011. According to Morningstar data, funds run by Bruce Berkowitz, Ken Heebner, and Bill Miller are among the worst performers in the diversified large-cap fund category this year. While the S&P 500 was up roughly 3.4% year-to-date through last week, the funds run by these gentlemen are down 11%-12%. All three were hurt by their bets on a more robust economic recovery than has actually developed so far.

Berkowitz loaded up on financial names in his Fairholme Fund (FAIRX), citing valuations as just too cheap to resist. At last glance, financial and real estate names accounted for roughly 85% of total fund assets. His biggest bets included battered names such as AIG (NYSE: AIG) and Bank of America (NYSE: BAC), which have lost roughly 40% and 19%, respectively, so far this year. The fund has lost 11.8% just since the beginning of 2011.

Heebner's CGM Focus (CGMFX) was weighed down by having more than a third of its assets invested in auto stocks at the end of 2010. The fund's former top holding, Ford (NYSE: F), fell 11% in the first quarter of the year when Heebner sold the stock. The fund was also hurt by some poor timing in commodity and financial stocks, selling commodity stocks at a loss in 2008 and reinvesting in financial names just as they went under later that year. CGM Focus now ranks in the worst 1% of all large-cap growth funds over the past three years.

And while Bill Miller gained fame when his Legg Mason Capital Management Value Trust (LMVTX) beat the S&P 500 Index for 15 consecutive years from 1991 through 2005, the fund has since lost its way, ranking behind 99% of the large-cap blend peer group over the past decade with a 2.5% annualized loss, compared to a 2% gain for the S&P 500.

Digging deeper
What these managers' recent struggles show us is that even those folks at the top of their stock-picking game won't stay there forever. While all three managers are undeniably talented investors, even the best fall to the bottom of the barrel once in a while. In fact, the longer a manager stays on top and posts outsized returns, the more likely it is that he or she will make a misstep or simply encounter an environment where his or her style of investing falls out of favor with the market. The key here is to stick with these talented managers over the long-run and not head for the hills as soon as they hit a rough patch.

Furthermore, it's not enough to just look at past performance when making your fund selections. You've got to look at how those managers earned those returns. For example, Berkowitz, Heeber, and Miller all like to take big bets on certain sectors of the market where they see opportunity. That strategy certainly helped them to create market- and peer-beating returns, but that same strategy can lead to severe underperformance when those concentrated bets don't work out. Risk cuts both ways, something investors are all too quick to forget when their fund is on a winning streak. I think in time, all three managers will produce better returns. But if you invest in funds like these, you've got to be willing to endure the lows if you want to cash in on the highs.

A lesson learned
However, even more important than what you can learn about the specific fortunes or misfortunes of these three managers is how you can apply these lessons in your own portfolio. When picking funds, don't bet the farm on the hottest-performing investments or asset classes. Remember, if a fund ranks at the top of its peer group in recent years, there's a good chance the market will correct for that and send it back down to earth in subsequent years.

If we take a look at what funds have been topping the charts in the past three years, one shouldn't be surprised to see several precious metals funds occupying many of the top slots:

Source: Morningstar Principia through 5/31/11.

Although gold, silver, and other commodities have been burning up the charts, and there are calls from many quarters for these asset groups to continue rising, this outsized performance won't last forever.

That means, just like investors who bought into the funds run by Berkowitz, Heebner, or Miller at their height of popularity because they were attracted by their peer-topping returns, so too will investors who buy into gold and silver funds at current prices likely be let down when those funds encounter a correction or even simply revert to producing more moderate returns, in line with long-term averages. You can make an argument for having a small precious metals allocation in your portfolio over the long run, but if you buy in now, realize that you're probably going to have to endure some underperformance not too far ahead in the future.

Remember, long-term returns should always be the primary focus for long-term investors. So don't let short-run price movements or performance get you off track. Find good managers and good funds, and stick with them as a part of your long-run asset allocation.

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