Rank alone not best for choosing funds

NEW YORK -- Wanted: M. fund w/ top 25 percent rank.

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 which ranked among the top 25 or even 50 percent 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 were 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.

Widening the search

Dash isn't against using the ratings and reviews, though he contends investors often rely on parameters that are too narrow. Limiting a search to funds that, for example, rank in the top 25 percent of their category can be too restrictive, he argues. He noted that many of the top funds were once those ranked in the middle 50 percent -- formerly B and C students that eventually made the honor roll.

"Just the fact that maintaining a top quartile performance is so difficult means you are leaving out some very good funds," he said.

Dash suggests investors instead employ rankings to screen out the worst-rated funds: "There is persistence. but the persistence is at the bottom, not at the top."

He also said that when evaluating funds, investors should hunt for qualities often shown by the top-shelf funds, including low expense ratios and portfolio managers who have been at the helm over long periods.

"Whenever you see ads or a presentation, there at the bottom in font size three will be written 'past performance does not guarantee future results,"' he noted with a chuckle, describing this small-print boilerplate message as the most important part of any pitch from a mutual fund.

Jeff Tjornehoj, an analyst with Lipper Inc., which evaluates mutual funds, contends investors should avoid simply funneling money toward areas that were recently strong because new investors will often arrive too late to reap sizable gains.

"I think how people tend to get messed up in their portfolio is by chasing the hot strategy. People sometimes fall prey to the myth that everything that's done well in the past year is poised to do better," Tjornehoj said. "Don't place any particular fund on a pedestal simply because your neighbor had good luck with it."

"A ratings service can tell you which funds have done well but it can't tell you why you need it. There are some funds that have done well in certain categories that are completely unsuitable for some investors." He offered high-yield bond funds, which invest in riskier debt, as an example of something perhaps ill-advised for investors seeking the traditional safety of bonds.

Investors too often focus on what's been hot recently rather than using logic, Tjornehoj said, explaining, "things that seem good now take precedence over other needs such as diversification. What investors should be looking for is moving toward discomfort" -- strategies and sectors that had been out of favor.

"Over time, those tend to move back into favor."

Part of the reason funds tend to do well in certain periods and fall back in others is that portfolio mangers often take up strategies that can work well in one environment but leave bruises in another, said Steve Schoepke, vice president of research and product development at AIG SunAmerica Asset Management.

"Certainly rankings are important but I think it might be more important to look at how those rankings really respond over the course of a market cycle," Schoepke said.

"When a manager does beat it year after year it's also something to look at closely," he said, referring to the benchmark against which a fund is measured. "It may point to an approach that has a fair amount of flexibility in allowing for selecting a range of stocks."

"There's an element of volatility in these rankings that varies whether you looking at a quarter or three years or five years but also when you add this added dimension of what phase of the cycle are you in," Schoepke said.

"It's convenient to pull up that one measure but I think the other side of it is recognizing that it is only one measure and that it's a fairly aggregate measure at that," he said of fund rankings.