Mutual Funds often boast spectacular ROIs. Sites like morningstar.com use these ROIs to rank funds, giving 5 stars for top performers.
Readers of this column already know where I'm headed: of course, 5-star top funds are a trap. It's confusing and counter-intuitive: a tennis player who's won almost every match in the last 5 years is likelier to win the US Open than a player who lost half her games this year; a business that's been profitable every year for the last 10 years is liklier to be profitable this year as well; why isn't it the case with mutual funds?
There are many reasons for that. The main one is the famous "Past performance is no guarantee for future performance" warning, which appears in every fund prospectus (maybe they should get more graphic, like the new warnings on cigarette packs?) Statistically, there's no correlation between past success and future success. Investments that do very well one year can be a dog this year (Internet stocks anyone?)
Another reason is that funds may luck out: a fund manager with 10 funds or a 100 funds can choose the most successful one and promote it (while perhaps closing the least successful ones to improve his overall record.) A maximum of a hundred random results is a pretty high number, but it's still random and does not reflect any intrinsic special quality.
Perhaps the most mysterious aspect of ROI is that the ROI of a fund is not your ROI. Take for instance an Internet fund, established in 1995 and look at its record at 2005. You won't be surprised to hear the fund had meagre results: after all, the .com bust of the early years of the last decade erased 98% of the value of some companies (pets.com anyone?). Still, since the fund was incorporated in 1995, it managed to see the bubble inflate before bursting. The overall ROI over this 10 year period was positive, around 5% total. Pretty dismal, but not nearly as bad as the average ROI for an investor in the fund. As you can expect, as the .com bubble grew, more investors joined the party. While very few invested in .com stocks in 1995, by 1999 and 2000 billions of dollars poured into the market, and most investors bought these funds when prices were beyond laughable. These investors lost almost all their investments when the market crashed. The average return for an investor in this fund is about -95%.
The moral of the story? If a fund boasts ROI of 50% over the last 2 years, by all means, jump on the bandwagon and buy it. But only if you can buy it retroactively, starting 2 years ago. Buying it today will be as good (or as bad) as buying a fund that lost 50% over the last 2 years. And how confident will you feel doing that?
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