Look at (But Don't Rely on) Past Performance
Judging past performance of a fund can be trickier than it might seem by glancing at five- and ten-year returns. Sectors or industries that are in vogue during one period may not be during the next. One spectacular year of 90 percent growth followed by four years of 10 percent growth, will average 26 percent growth per year. This average would not be a good indicator of how that fund is performing at the end of the fifth year, when you are thinking about buying. Also, a sector that has not fared well over a stretch of time may be on the upswing due to new products, consumer needs, or public awareness (for example, socially responsible stocks). This won't show up in past performance.
The same holds true for the large- and small-cap companies. A fund that invests in small companies will not see large returns when the trend leans toward the large corporations, as it did in the late 1990s. The best you can do is look at each measure of past performance, read up on future expectations, and try to make an informed decision. Remember this: long-term five- and ten-year returns are important, but they are only part of the larger picture.
A mutual fund's past performance is less important than you might think. Sales materials — like ads, rankings, and ratings — almost always highlight just how well a fund has performed in the past. But studies show that future performance has no tie to the past. Last year's top fund can easily become this year's loser.
The long-term success of your mutual fund investments is partially dependent on several factors, including:
Each fund's operating expenses, fees, and sales charges
Any taxes due based on the fund's distributions
The size of the fund
The age of the fund
Any changes in fund management or operations
The fund's volatility and risk profile
When selecting a fund family, it is often suggested that you look for one that has been around a while. The one exception concerns emerging industries, such as tech stocks, an area in which all of the newer fund families have been around for about the same length of time. The better-established fund families can show you ten-year returns, which you can compare against funds in other fund families. They can also give you an indication of how the fund has fared during the bear markets and how long it took them to recover. Naturally, some of this will depend on the fund manager, but you have a better chance of finding a fund manager with ten years of experience at the helm of a fund at an older, more established company. Look at the ten-year returns and see if the same fund manager was there over that time period. If you look at ten-year returns and see that the current manager has only been on board for three years, those ten-year returns won't mean as much. It's like looking at the last ten years of a baseball team that only acquired its superstars in the past three years; management experience makes a big difference.
Additionally, you should compare the mutual fund that interests you with other comparable funds. If the fund you like had a 10 percent return last year and other similar funds were also around 10 percent, then the fund is performing as expected. However, if the fund is bringing in 10 percent and comparable funds in the same category are bringing in 12 and 15 percent, you can do better without changing your goals or choosing a more (or less) risky fund. All you have to do is find another fund in the same category.
Liquidity is a key benefit of mutual funds. You can sell a fund on any business day, and you'll get that day's closing price — unless, of course, your order comes after the closing bell (4:00 p.m. ET), which counts as placing the order on the following day.
Once you finally make a decision, expect to be in the fund for at least one year, usually five or more. Mutual funds are not generally thought of as a short-term investment, but sometimes market conditions can dictate change earlier than you had planned. If you've invested in a fund that was on the upswing and now it's heading back down (or “correcting”), you may be better off selling before share prices drop lower. You'll almost always have the opportunity to revisit the fund after it stabilizes, when you'll have a chance to benefit from the next round of growth.
