Don't Buy Top Ranked Funds

March 21, 2007

We've said it before, and we'll say it again: when shopping for mutual funds, resist the urge to purchase top performers.

Given the scads of mutual funds out there, investors might be tempted to turn to the want ads rather than sort through heaps of funds in hopes of finding a good match. More often, befuddled investors depend on fund rankings to bring a cool empirical eye to their search. But those who invest solely based on rankings risk disappointment.

'Using historical top quartiles to predict top quartile performance is a bit like rolling the dice,' said Srikant Dash, an index strategist at Standard & Poor’s Corp. S&P found in a recent study that few funds that ranked among the top quarter or even top half of their peers managed to consistently maintain their performance.

In the past five years, only 13.2 percent of large-cap funds, 9.9 percent of mid-cap funds and 10 percent of small-cap funds were able to remain ranked among the top half of funds for the entire period.

The top 25 percent ranking proved even more daunting a challenge, with only 3 percent of large-cap and 2.5 percent of mid-cap funds staying in that zone for five straight years. Stats for small-cap funds were even more grim: None was able to hold onto a top 25 percent ranking for the entire period.

'The numbers are similar to what would happen if you just pick a fund randomly,'" Dash said.


Buying the funds at the top of this year's performance chart is step one of the all-to-common buy-high/sell-low cycle that is probably responsible for destroying more fund investor wealth than loads, high fees, and manager ineptitude combined (step two is selling that fund after its almost inevitable subsequent poor performance).