Gotta Get Your Mutual Fund Ideas from Somewhere

Filed in archive Investing on July 24, 2006

I'm generally a big fan of Selena Maranjian of Motley Fool. She cranks out a lot of good financial advice.

But you've probably already figured out that I'm going to disagree with her about something.

Here it is. In discussing what mutual funds to pick, Maranjian is telling her readers to go with an index fund because many mutual funds that average high returns are in reality coasting off of one great year:

"If, in a five-year period, a fund earns 8%, 11%, 4%, 12%, and 33%, its average annual return will be about 13%. That might look respectable, but in reality, it exceeded 13% in only one of those five years. That 33% return, an "outlier" in statistical terms, has skewed the average. It might not be a problem if you were guaranteed 33% every five years, but that's not likely."

This is all kinds of crazy, and it's easy to pinpoint why. Maranjian never brings up the point that the market indexes don't regularly return double-digit growth, but tells you that if a fund manager doesn't, you should just go with the index fund.

Why? If the fund manager is consistently beating the index fund, that's what matters. Using her example, yes, a 33% return one year might be an outlier, but what did the overall market do? What if the overall market's returns over the same 5-year period were 7%, 9%, 3%, 12% and 27%? Well, then the index fund doesn't look so great in comparison to the hypothetical fund she mentions.

Markets go up and down, and it's necessary to use an average to smooth out the crazy swings that can happen from year to year. A particular mutual fund may be more volatile than an index fund, but its track record shouldn't be shunned just because it has an outsized good year next to modest returns in other years.

Many of the best mutual funds are value funds, meaning the stocks purchased within the fund are seen to be underpriced, often because they are out of favor. Chosen correctly, these stocks can have huge rebounds that make a certain year's returns look outrageous, but of course in a buy-and-hold strategy, isn't that what the fund manager wants? Sure, you'd like the returns to be smooth, but you're counting on big growth and you're willing to wait for it. Who cares how it's spread out?

Index funds are great, especially for investors that don't want to spend a lot of time or get hit with a lot of fees. But there are mutual fund managers out there who consistently beat the markets when averaged over reasonable timeframes (5 years or more), and Maranjian's advice simplistically acts as if greater returns are just an anomaly, when in reality they are often the big payoff for a fund's long-term value strategy.