Don't Be Swayed by These Hot Returns

Don't Be Swayed by These Hot Returns

When it comes to mutual fund investing, we all know that we should closely examine any fund before we buy, taking a careful look at management, the investment process, and expenses. But the fact is, most investors choose funds based on one simple factor: recent performance. After all, it's as hard to ignore a fund that has been posting market-crushing returns as it is to buy a fund that has been a short-term laggard. And this near-term performance picture is about to undergo a major facelift.

Bad old days no more
In a recent article for MarketWatch, Chuck Jaffe noted that mutual fund returns are about to take a giant leap forward. As we reach the five-year anniversary of the collapse of Lehman Brothers and the ensuing 50% decline in the broad stock market, mutual fund companies will begin rolling that period of horrific performance off their trailing five-year return numbers. That will lead to five-year returns getting a huge boost at most equity-centric mutual funds. Jaffe points out that the average large-cap growth fund had a five-year annualized return of 6.38% as of the end of August 2013, according to Morningstar data. Even if the market remains flat for the rest of 2013, the average large-growth fund will have a five-year return of 15.16% by the end of the year. That means trailing returns will more than double at some funds.

So could investors end up being swayed by these new and improved fund returns? It's certainly possible. But in the grand scheme of assessing fund performance, even a five-year period isn't adequate to get a good idea of how a fund will perform over the long run. That's why I've always pushed hard for investors to carefully consider long-term performance when evaluating funds. That means looking at 10- and 15-year performance track records to get a more complete picture. The key here is to examine how a fund has performed in both positive and negative market environments. Five years may give you some idea of historical fund performance, but that period might only include a bull market, as five-year returns soon will once the last bear market rolls off. So if you evaluate funds only on one-, three-, or five-year returns, you may not get a thorough view of what you can expect from any mutual fund.

Focusing on short-term performance can not only lead you to pick hot funds that haven't measured up over the long run, but it can also cause you to pass over some great funds that may have encountered temporary troubles. That could end up working against your portfolio over time.

The real test of time
One fund whose first-rate, long-term track record has been partially obscured by its short-term stumbles is Sound Shore (SSHFX). This value-oriented fund has been sticking to its guns through thick and thin for decades. Two of the fund's three managers have been on board since its 1985 inception, using the same cautious, value-leaning investment approach. Management looks for stocks it believes are undervalued because the market is placing too much importance on a short-term stumbling block. But the fund's patient approach means it can move out of step with the market from time to time. Over the most recent five-year period, Sound Shore ranks behind two-thirds of its peer group, due in large part to lagging performance in 2010 and 2011. But don't let that distract you from the fund's fine long-term performance record. Over the past 15 years, it has racked up a 7.5% annualized gain, placing it ahead of 78% of all large-value funds.

Sound Shore's portfolio is fairly concentrated, with just 42 holdings, but the team knows how to make its picks count. The fund leans heavily into the battered financial sector and includes several companies that have posted returns more than double those of the S&P 500 Index over the past year, including Bank of America , , and Citigroup . All of these stocks were purchased after their shares were beaten down on concerns over general weakness in the sector and at those institutions specifically. The team at Sound Shore thought the companies were in better shape than the market believed and while that thesis took time to play out, shareholders have been amply rewarded as of late.

There are many more excellent funds out there sporting less-than-impressive, short-term track records that are still great investments for the long run. And there are just as many funds with hot short-term returns that investors should probably avoid. Looking at past performance won't give you a 100% guarantee for the future, but taking a longer view instead of focusing on shorter time frames should help ensure that only the best funds make it into your portfolio.

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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. She has no position in any stocks or funds mentioned. The Motley Fool recommends and owns shares of American International Group and Bank of America. It also owns shares of Citigroup and has the following options: long January 2014 $25 calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published