I consider myself a fairly patriotic person. Nevertheless, I have been unable to get the least bit enthusiastic about the Winter Olympics, try as I might. I did manage to catch a few minutes of the luge competition, and I will probably tune in for my favorite event -- ski jumping. For the most part, though, my involvement amounts to little more than checking the medal count from time to time and hoping we can overtake those pesky Norwegians.
As a snow lover and all-around sports fan, I've been puzzled as to why the winter Games hold little appeal for me. It could be that I don't exactly find many of the events to be thrilling spectator sports. (Does anyone really enjoy watching curling or cross-country skiing?) The most likely reason, however, is that the overall competition seems to be dominated by things like ice dancing or snowboarding -- events that are entirely subjective in terms of judging.
I like my winners to be determined by concrete criteria -- the fastest time, the most points, the longest jump -- not whether the Russian judge thought a program deserved a 9.1 or a 9.2. My wife, a big ice skating fan, informs me that this isn't exactly how the scoring works, but you get the idea.
You be the judge
When it comes to investing, though, the process of separating the medal winners from the rest of the field is equally subjective. Take the always-competitive mutual fund category, for example. There is an extensive list of attributes that must be evaluated closely to determine which participants are truly among the elite: management tenure, portfolio composition, relative performance, expense ratios, tax efficiency, and so on.
As an impartial judge, you must assign a score to each of these components and rank them in order of importance. In this inexact science, there may not be a right way to pick the winners, but there are most certainly plenty of wrong ways. One of the most egregious -- and most common -- is to neglect all of these variables and base the scoring entirely on one factor: speed. "What's wrong with that?" you say. "Shouldn't we be on the lookout for funds that race out to the lead?"
Not exactly. It's where they cross the finish line that counts.
Too much speed can be dangerous
Short-term performance can be a misleading way to measure a mutual fund. Not only is it a backward-looking metric, but it is also an unreliable method of gauging a fund's long-term potential. History has taught us that it is exceedingly difficult for even the best funds to stay on top for more than a year or two.
It's worth noting that legendary manager Bill Miller has steered his Legg Mason Value Trust to a top-decile ranking only once in the past seven years. Yet there is something to be said for consistency, since the fund has beaten 98% of its large-cap blend rivals over the past decade.
Unfortunately, many shortsighted judges -- including a few mainstream financial publications -- love to award gold medals to the funds with the hottest returns over the prior year. Glory can be fleeting, though. Here's a quick look at a few previous gold-medal winners, and how their careers have since fallen off track.
Aim Opportunities II A (AMCOX)
Top two holdings: Moody's
In the heady growth days of 1999, this fund was right up there with the leaders, finishing the year with a powerful 125% gain. In the years since, though, it has lost some of its swagger. That will happen when you deliver an anemic trailing five-year annualized return of 0.39% and land squarely in the bottom 1% of your peer group.
While undergoing four managerial changes over the past couple of years, the fund has shifted gears from growth to value to blend. These days, the portfolio contains a little of everything -- including numerous short positions. Flexibility or lack of focus? You make the call. Either way, you will pay a hefty 5.5% upfront sales load (before breakpoints) and an ongoing expense ratio that can reach as high as 2.67% whenever the fund outruns its benchmark. Given its dismal track record, though, I wouldn't worry about that happening too often.
Apex Mid-Cap Growth (BMCGX)
Top two holdings: CMGI
Despite the name, this fund is actually loaded down with micro-cap growth companies, one of the most volatile corners of the market. At the same time, the manager has a preference for some of the raciest high-tech industries, as evidenced in the top two picks of CMGI and TiVo. In fact, those speculative former highfliers -- each of which has plummeted more than 40% from its previous highs -- represents nearly 14% of the concentrated portfolio.
As might be expected, the fund has seen its share of ups and downs, with one of the most extreme standard deviations in the small-cap growth universe. Unfortunately, the up periods have been few and far between. Shareholders did enjoy an exhilarating 165% return when the market rebounded in 2003. Unfortunately, that one gold-medal performance has been surrounded by catastrophic tumbles in five of the past six calendar years.
All told, the fund has lost nearly 12% per year over the past decade, trailing 99% of its rivals over that period. For those few not scared away by that abysmal performance, there is also an exorbitant 4.7% in annual expenses to deal with.
Ultra Semiconductor (SMPIX)
Top two holdings: Intel
Often, funds that rack up triple-digit annual returns are simply in the right place at the right time. For example, health-care sector funds were all the rage in 2000, and several years later, precious-metals funds far and wide enjoyed a broad surge in commodities prices.
This fund is no exception, riding the rally in tech stocks to an eye-catching 145% gain in 2003. Unfortunately, that one stellar year was sandwiched between painful losses of 70% the year before and 35% the year after. The fund's tumultuous track record -- bottom of the barrel to top of the charts back to bottom of the barrel -- is a byproduct of its highly leveraged strategy, which seeks to produce 150% of the return of the Dow Jones U.S. Semiconductor Index -- sort of an index fund on steroids.
Obviously, this strategy tends to magnify gains and losses in the chip industry, particularly those of market leader Intel, which accounts for nearly one-fourth of the fund's assets. Unless you happen to be a nimble market timer, save yourself the anxiety.
Watch out for moguls
Clearly, it takes more than a temporary burst of speed to get to the bottom of the hill. Funds like those above have no trouble gaining momentum in a favorable market, but they usually careen out of control whenever a few moguls cross their path. Over the long haul, each quickly relinquished its brief lead and finished near the bottom of the standings. By contrast, the true gold medalists sacrifice a little speed to make fine course adjustments along the way.
Instead of cheering for funds that have recently vaulted to the top, ask yourself why these statistical outliers stood out from the rest of the pack. In many cases, it was not deft management that got them there but a risky strategy that could just as easily lead to a spectacular crash at the next turn. Even if the top-notch performance was well earned, it stands to reason that the stocks that underpinned the sharp advance have since become overvalued and are likely to fall out of favor.
When sifting through the mutual fund universe in search of the next gold medalist, Motley FoolChampion Funds editor Shannon Zimmerman looks past flash-in-the-pan funds and focuses on those that deliver steady gains year in and year out. Those that have made the cut all offer an experienced management team, below-average expenses, and an outstanding long-term track record. Better still, 34 of the newsletter's 36 recommendations have made money for their shareholders, producing an impressive average gain of 20.2% since they were added -- doubling the return of their benchmarks.
Like to add a few of these winners to your team? Join the party for 30 days at no charge.
Fool contributor Nathan Slaughter is still not brave enough to venture down a black ski trail. He owns none of the companies mentioned. TiVo and Moody's are Motley Fool Stock Advisor recommendations. 3M is a Motley Fool Inside Value pick. The Fool has a disclosure policy.