How do you use fund performance data? Every investor has his own opinion on the topic, from those who obsess about every basis point when poring over return statistics to those who ignore past performance entirely.
Of course, there's no right or wrong answer. How one uses performance data is a matter of personal preference. But some investors make the mistake of looking at past performance alone when making investing decisions, and it's easy to understand why. Trailing-return data, for example, is easier to understand and takes a lot less time to research than a fund manager's strategy and process. Furthermore, performance data speak directly to what many investors care about most: how investing in a fund might be able to help their money grow. And despite all he disclaimers about past performance not necessarily representing future result, some investors have a hard time resisting the data.
To help put performance data into context, we asked some of Morningstar's in-house experts how they use the data to evaluate funds. Here are their replies.
Jeff Ptak, president and chief investment officer of Morningstar Investment Services
Performance should be a single input into a process, not a divining rod. It really should play a small, confirmatory role. For instance, what does the fund's track record tell you about its investment style? What does it reveal about how the manager has executed his approach? Can you reconcile the way the fund has performed to the manager's stated investing discipline? How has it done during certain, more-telling time periods (such as market downdrafts or sharp rallies)?
Ideally, one would consider performance at the very end of the diligence process, with other factors (such as, prudence and repeatability of strategy; manager's depth, breadth, and continuity; investor-centricity of manager and parent firm; competitiveness of expenses) taking precedence. In that way, past performance doesn't come to tinge the way we look at other factors that are arguably more predictive. The performance assessment itself should not be too cookie-cutter--one size doesn't fit all, it really depends on the makeup of the fund concerned--and tempered by the reality that returns tend to be mean-reverting, with stylistic biases and luck playing a big role in explaining out- and underperformance.
(Morningstar Investment Services, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.)
Russ Kinnel, director of mutual fund research
Performance data are remarkably informative. Their predictive power is limited, but you can still learn quite a lot about performance. For the big picture, look at how the fund has done during the manager's tenure versus its benchmark and peer group. Too often investors look at short time periods. If a manager has been at the fund for 12 years, you should look at the whole 12 years. On the flip side, if the manager has been there for one year, you can throw out the history beyond that.
Just as useful, however, is the annual-return data. Even if a fund has a great 10-year return, it might have had two awful years along the way. I want to see how it did in absolute terms and compared with its category and benchmark. For starters, you should be prepared for losses in a single year that are even a little greater than any past loss. Check out a stock fund's performance in 2000, 2001, 2002, and 2008 and you'll know how it's done in bear markets. Check out its returns in years like 2003 and 2009 to see how it did in rallies. In addition, you want to know how much it diverges from peers and the benchmark so you can use it properly in a portfolio and have realistic expectations.
Christine Benz, director of personal finance
For me, performance data are only helpful when used in conjunction with my understanding of a fund's strategy. If it's a fund I don't know well, I use past performance to help me understand what kind of style the manager has. If it's a fund whose strategy I think I understand, I use performance as an assurance that the fund is still filling the role I thought it would.
For example, has the fund tended to hold up well on the downside, indicating a bias toward conservatism? Does it exhibit the opposite pattern, falling further than its peers in down markets but screaming ahead during rallies? Or is there no rhyme nor reason behind when the fund does well and when it does not? That's often an indication of an idiosyncratic strategy that's changeable or highly dependent on the fortunes of its top holdings.
I conduct that kind of analysis initially when I'm getting to know a fund, and on an ongoing basis to make sure a fund is performing in line with my expectations. When I was a fund analyst, I used to pride myself on knowing which of my funds would be doing poorly in a given market environment and which weren't--even before I saw their returns or rankings. That told me I understood the strategy and the role that fund should play in an investor's portfolio. If I knew a large-cap fund usually bought smaller large-cap firms than its peers, I'd expect it to do well in a smaller-cap-led rally, or I'd know that a given manager would probably be benefiting from strength in biotech stocks because he always had a bias toward that industry.
We will continue to see more experts' replies in Part 2.
