(Podcast) How to Predict Fund Performance

The phrase “past performance is not an indicator of future performance” is a frequently written and spoken legal disclaimer for virtually all investments sold by Wall Street. Yet, hardly anyone from individual investors all the way to investment sales people really act like they believe it.

Asset flows inevitably gravitate into funds with the hottest historical performance. And if a fund happens to be christened with a 4 or 5-star rating, the money really pours in.

In fact, the very first thing that retail investors and professionals infatuate themselves with is historical performance.

The herd mentality with picking mutual funds goes something like this: “The _____________ (fill in the blank) fund has easily outperformed the S&P 500 (NYSEARCA:VOO) over the past ____________ (fill in the blank) years.  It’s a proven winner!” And that’s generally how buy decisions are made. Never mind how the fund’s benchmark is irrelevant or how much risk the fund actually takes or how much the fund charges. None of these petty details matter to the historical performance enamored investor.

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Yet, people who focus exclusively on past performance are doomed to future underperformance. It’s one of those predictable ironies, that’s confirmed in new research from Morningstar.

The study highlights the mistake of emphasizing historical performance.

”While we think it makes sense to consider a variety of factors when choosing funds, our research continues to find that fund fees are a strong and dependable predictor of future success,” said Russel Kinnel, chair of Morningstar’s North America ratings committee. In other words, historical performance isn’t a determining factor in future returns.

Kinnel added, “We found that the cheapest funds were at least two to three times more likely to succeed than the priciest funds. Strikingly, our finding held across virtually every asset class and time period we examined, which clearly indicates that investors should keep cost in mind no matter what type of fund they are considering.” (You can listen to Ron DeLegge’s full podcast interview with Russel Kinnel on the Index Investing Show.)

Highlights of the Morningstar study include:

• The lowest-cost U.S. stock funds succeeded three times as often as the highest-cost funds. The least-expensive quintile had a total return success rate of 62%, compared with 48% for the second-cheapest quintile, 39% for the middle quintile, 30% for the second-priciest quintile, and 20% for the most-expensive quintile.

• International-equity funds had a 51% success ratio for the least-expensive quintile compared with 21% for the most-expensive quintile.

• Among taxable-bond funds (NYSEARCA:BND), the least-expensive quintile delivered a 59%  success rate versus 17% for the most-expensive quintile. Municipal bond funds (NYSEARCA:MUB) showed a similar pattern, with a 56% success rate for the least-expensive quintile and 16% for the most-expensive quintile.

How does your mutual fund portfolio compare? Get a free Portfolio Report Card diagnosis to find out. Your fund portfolio will be analyzed, graded, and a accompanied by a one-page report.

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