Introduction
If you are investing in a mutual fund, especially a stock fund, you likely plan to hold it for at least three years. Making this assumption, there is rarely a need to look at time periods of less than three years. However, this is not to say that short-term returns of, say, one year, are irrelevant. In fact a one-year return for a mutual fund that is incredibly higher than that of other funds in its category can be a warning signal.
Yes, strong performance can be a negative indicator, for a few reasons: One reason is that an isolated year of unusually high returns is abnormal. Investing is a marathon, not a race; it should be boring, not exciting. Strong performance is not sustainable. Another reason to shy away from high short-term performance is that more assets are attracted to the fund.
A smaller amount of money is easier to manage than larger amounts. Think of a small boat that can easily navigate the shifting market waters. More investors mean more money, which makes for a larger boat to navigate. The fund that had a great year is not the same fund it once was, and it should not be expected to perform the same in the future.
In fact, large increases in assets can be quite damaging to a fund’s prospects for future performance. This is why good fund managers close funds to future investors; they can’t navigate the markets as easily with too much money to manage.
Understand and Consider Market and Economic Cycles
Talk to ten investment advisors and you’ll likely get ten different answers about what time periods are most important to analyze to determine which fund is best from a performance perspective. Most will warn that short-term performance (one year or less) won’t tell you much about how the fund will perform in the future. In fact, even the best mutual fund managers are expected to have at least one bad year out of three.
Focus on the 5- and 10-year Periods for Mutual Fund Performance
Just as some fund managers are bound to have a bad year from time to time, fund managers are also bound to do better in certain economic environments, and hence extended time frames of up to three years, better than others.
For example, perhaps a fund manager has a solid conservative investment philosophy that leads to higher relative performance during poor economic conditions but lower relative performance in good economic conditions. The fund performance could look strong or weak now, but what may occur over the next two or three years?
Considering the fact that fund management styles come in and out of favor and the fact that market conditions are constantly changing, it is wise to judge a fund manager’s skills, and hence a particular mutual fund’s performance, by looking at time periods that span across differing economic environments.