The winning edge

Kiplinger's Personal Finance Magazine, August, 1998 by Marc L. Schulhof

As beguiling as a link between past and future performance might be, it doesn't exist. Decades of academic research suggest that the best funds in any given period will not necessarily be among the best funds in subsequent years. Instead, researchers credit occasional recurring high returns to such factors as hot streaks, investment criteria (such as a penchant for blue-chip companies with low price-earnings ratios) that coincide with market conditions, or a manager's superior analysis of companies he invests in.

Still, with this issue's winners' lists as a backdrop, we decided to test the conventional wisdom against the real-world performance of a group of top funds. Just as the academics told you, we found that blindly chasing the winners won't guarantee anything--but that past returns do offer a solid starting point for picking a fund.

We revisited the stock funds that turned in the best one-, three- and five-year records in 1990, 1991 and 1992--and whose managers did not change during the five years after the award-winning performance. For each year, our winners' list included the top ten performers for each time period in each of four categories: aggressive' growth, growth-and-income, long-term-growth and diversified international. Then we compared the funds' total returns over those five years with the average for funds in their category.

AND THE RESULTS ARE ...

AS EXPECTED, JUST ABOUT HALF OF THE WINNERS posted above-average returns the next five years. But we detected no patterns to the results by year or by category. In other words, it look as if serendipity accounted for subsequent results of these one-time winners.

But wait: When you look at the winning funds that went on to achieve above-average returns, it turns out that more than 90% of them shared two or more of the following characteristics (and 15% had all four):

Lower-than-average expenses. While most of the underperforming funds charged higher-than-average expense ratios, the vast majority of funds that beat their category averages over the next five years had lower expense ratios than did their peers.

Lower-than-average assets. Size counts, but inversely. In all four categories, the majority of outperforming funds had fewer dollars to invest than the other funds in their category. That's strong evidence that small funds may sometimes have an advantage, especially when a manager's investment criteria yield only a handful of truly desirable stocks.

Lower-than-average turnover. The managers of most of the outperforming funds replaced the stocks in their portfolios less frequently than did their peers. Because the commissions and other costs of trading are in addition to a fund's expense ratio, fewer trades mean higher returns.

Higher-than-average volatility. Most of the above-average funds the next five years also had above-average volatility, which is the most common measure of risk. That's not surprising given the strong bull market we tracked. In a down market, that volatility might have had the opposite effect and kept some funds off the winners' lists.

SO BUY THE WINNERS? MAYBE

WINNERS WON'T ALWAYS BE WINNERS, BUT THEY'RE still a good place to start your search. The other factors, too, will begin to point you in the right direction. To help you along, we placed an asterisk (*) beside this year's one-, three- and five-year winners that share all four of the characteristics just described. (Look for it in the aggressive-growth, growth-and-income and long-term-growth categories. No international fund met the criteria.) If any funds are poised to repeat past successes during the upcoming five years, it is these.