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Strong Evidence That Fund/ETF Prices Can Get Too High

Here's a puzzler: As a relatively long-term investor, you still want to maximize your returns. You find you have some extra money to invest and you've narrowed down your choice to two stock funds. So which of the following two funds should you pick? I'll give you my answer shortly.

  • Choice 1) One that has a 5-year annualized return of 16+%, or
  • Choice 2) One that has a 5-year annualized return between 2 and 6%?

This isn't a trick question - it is the kind of choice investors are actually making all the time.

ourse, you might argue there isn't enough information here to make a sound decision. (E.g. Maybe one fund has a much higher expense ratio, or perhaps, recently changed managers; such information might be crucial to your decision.) Some might also be inclined to conclude that each fund should have an equal chance of besting the other going forward believing that past performance is basically irrelevant to predicting future performance.

But assuming you do not have any other information, or such additional information is not enough to sway you one way or another, the performance data would appear to loom large. Therefore, it's an easy bet to assume that the majority of investors would pick choice 1).

Although I can't give an answer that will always be true for every such fund comparison, my choice would most likely be 2).

In the remainder of this article, I will explain why, given just this limited performance information on the two choices, I would lean strongly to 2).

The best way to demonstrate why I think 2) is usually a better choice is to show some actual examples that are likely not just isolated instances.

Let's go back to a little more than 4 years ago. If, at that time, you examined a chart of the best performing funds/ETFs from a multitude of fund categories, based on one year performance data, you would have observed that through the end of 2010, there were only small number of funds that returned 16% or more annualized over the prior five years. These exceptionally strong-returning funds at that time are shown in Table 1 below.

A 16+% per cent annualized 5-year return for a fund is a relatively unusual occurrence, even when stocks have been strong as they have been between 2010 and now. And since stock fund performance at the end of 2010 had still not escaped the effects of the severe 2007-2009 bear market, most funds/ETFs had just begun to show positive five-year annualized returns.

Each of the funds, then, in Table 1 would be similar to the one described in choice 1) above. The average annualized 5-year return of these funds was 20.2%.

Table 1: Top Performing Funds/ETFs Based on 2010 Performance
with Best 5-Yr. Annualized Performance Between 2006-2010
Fund Name 2011 Return 2012 Return 2013 Return 2014 Return Average
1 Yr.
Return
2011-2014
Oppenheimer Gold & Special Minerals A
(OPGSX)
-25.69% -9.14% -47.83% -15.39% -24.5%
Tocqueville Gold
(TGLDX)
-15.85 -8.72 -48.26 -2.67 -18.9
BlackRock Latin America Inv A
(MDLTX)
-23.96 8.47 -13.72 -9.60 - 9.7
T. Rowe Price Latin America
(PRLAX)
-25.17 10.30 -15.95 -13.08 -11.0
DFA Asia Pacific Small Company I
(DFRSX)
-20.13 24.02 1.65 -8.20 -0.7
DFA Emerg Mkts Small Cap I
(DEMSX)
-22.62 24.44 -1.38 3.00 0.9
Matthews India Inv.
(MINDX)
-36.48 31.54 -5.90 63.71 13.2
 
Average 1 yr. return for all diversified US stock funds   12.7
Average 1 yr. return for International stock funds   4.7

Keeping in mind that the above 7 funds were in rarefied air as the best performers over the preceding 5 years in their respective categories, pay particular note to how poorly 6 out of the 7 subsequently performed on average between 2011 and 2014 as compared to the average for all diversified US stock and International funds.

One can conclude, at least at the start of 2011, that inferring that those funds with large annualized 5-year returns were the place to remain invested (or to invest new money) over the following 4 years would largely have turned out to have been wrong-footed choices; most subsequently proved to be severely underperforming.

Instead of looking at the best performing funds/ETFs from about 4 years ago, let's merely look at a handful that were the largest by assets, and additionally, had five-year returns of 2 to 6% on Dec. 31, 2010; these funds are shown in Table 2 below. Each of these funds, then, would be similar to the lower performing one described in choice 2) above.

Table 2: Performance of Largest Stock Funds/ETFs at End of 2010
with 5-Yr. Annualized Performance of 2% to 6% Between 2006-2010
Fund Name 2011 Return 2012 Return 2013 Return 2014 Return Average
1 Yr.
Return
2011-2014
SPDR® S&P 500
(SPY)
1.89% 15.99% 32.31% 13.46% 15.9%
American Funds Growth Fund of Amer A
(AGTHX)
4.89 20.54 33.79 9.30 17.1
Vanguard Total Stock Mkt Idx Inv
(VTSMX)
0.96 16.25 33.35 12.43 15.7
Fidelity® Contrafund®
(FCNTX)
-0.14 16.26 34.15 9.56 15.0
American Funds Capital World Gr & Inc A
(CWGIX)
-7.53 19.12 24.84 4.02 10.1
American Funds Invmt Co of Amer A
(AIVSX)
-1.76 15.60 32.43 12.09 15.6
American Funds Europacific Growth A
(AEPGX)
-13.58 19.21 20.15 -2.64 5.8
 
Average 1 yr. return for all diversified US stock funds   12.7
Average 1 yr. return for International stock funds   4.7

In fact, back on Dec. 31, 2010, the majority of stocks funds actually returned in the 2 to 6% range over the prior 5 years. According to the Wall Street Journal, the average diversified US stock fund returned just 2.7% annualized, while the average international fund returned 2.9% ann. between 2006 and 2010.

But here too in 6 out of the 7 cases in Table 2, the selected funds'/ETF subsequent average full year performance from 2011 through 2014 outpaced the performance of the previously top performing funds in Table 1, that is, those which were similar to choice 1). And in all 7 cases, Table 2 funds subsequently outperformed the yearly average for all diversified US stock funds or, if so classified, that for international funds. (Note: Although 4 of these largest funds were American Funds with loads, or sales charges, they still outperformed the average fund; however, I do not recommend owning funds with a load.)

What does this suggest? Although future fund/ETF performance results may not always resemble these results, funds with extremely high performance over the prior 5 years frequently won't be the best places to put your money over the upcoming years. Conversely, funds that may not appear to have done well, at least in terms of matching investors expectations of perhaps 9 to 10% annualized returns, may frequently be considerably better places to invest your money for the next number of years than funds that have already exhibited super-sized returns.

These are similar to the types of outcomes that have happened in the recent past. When back in 2000 as well as 2008 stock prices got to extremes, those types of stock funds whose returns were at or above those shown for funds in Table 1, their subsequent returns tended to suffer.

Examples include almost all US stock funds in late 2000 when the average ann. US stock fund returned about 18% for the prior 5 years; by 5 years later, the average 5-year return was 0%. However, those categories of funds that did not participate fully in the excessive run-up, namely Real Estate, Natural Resources, or Emerging Markets, compiled outstanding performances over the following 5 years.

And in mid-2008, when Natural Resources, Utilities, and International funds 5-year ann. returns soared while average diversified US stock funds' ann. returns were just a little above the range given in choice 2), by 5 years later, there had been a complete reversal: All 3 of these specific categories were showing negative annualized returns while the average US fund was showing an 8.8% ann. gain.

In today's market, we can find an unusually high number of funds whose 5-year ann. return is 16% or above, as of mid-March. For example, here is a random listing of some well-known funds in each of the major fund categories meeting this criterion:

  • Vanguard Small Cap Growth Index Inv (VSGIX). Small Growth
  • T. Rowe Price Mid-Cap Growth (RPMGX). Mid-Cap Growth
  • Fidelity® Growth Company (FDGRX). Large Growth
  • Fidelity® Mid Cap Value (FSMVX). Mid-Cap Value
  • Vanguard Mid Cap Index Inv (VIMSX). Mid-Cap Blend
  • Schwab Small-Cap Equity (SWSCX). Small Blend
  • Oakmark Select I (OAKLX). Large Blend
  • Delaware Value® A (DDVAX). Large Value
  • Invesco Small Cap Value A (VSCAX). Small Value
  • Vanguard Health Care Inv (VGHCX). Health Care
  • American Century Real Estate Inv (REACX). Real Estate

Although we won't know for sure how each of the above 11 funds (or the large number of others with very large ann. 5-yr. returns) will do over subsequent years, my research suggests that they are more likely to underperform otherwise good funds whose ann. performance might generally be a lot closer to the 2 to 6% range. Given the current long-standing bull market, these latter funds are certainly not in the majority these days. But, many such ones do occur right now in the Foreign Large Blend, Emerging Markets, and Energy categories. These, then, are the main categories of funds that appear likely to do well in the years ahead.

Examples of recommended funds/ETFs in these categories are

  • Vanguard European Stock Index (VEURX) or Vanguard FTSE Europe ETF (VGK)
  • Vanguard Emerging Mkts Stock Idx (VEIEX) or Vanguard FTSE Emerging Markets ETF (VWO)
  • Vanguard Energy Fund Investor Shares (VGENX)

See the following link for a complete listing of my recommended stock/bond funds/ETFs that are aimed at maximizing returns over the next three to five years.

Of course, there is certainly no guarantee that selected funds in the choice 2) category will start to do better than those in the choice 1) category quickly (as in the next year or even two). But investors should realize that these type of counter-intuitive flip-flops in performance are what make it so difficult for investors to pick the funds that have the best chance of outperforming in the 4 or 5 years ahead.

To summarize: For most investors, even long-term types, there is a strong attraction to funds with unusually excellent-appearing track records spanning the last several years. These funds may continue to excel initially. But, especially after a few years, the outcomes frequently will turn out to have gone in the opposite direction. While it may be extremely hard to implement, patience in awaiting your choice 2) picks to start coming out ahead is what is required for eventual success.

 

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