This article is adapted to the web from Sound Mind Investing. In my opinion it is one of the few investment publications that "tells it like it is." You can visit them at (For those who may be uncomfortable with the apparent religious orientation of the publication; rest assured that that aspect is not intrusive.)

Dave King

Sound Mind Investing
AUGUST, 1996

Is There Predictive Value in the
Long-Term Track Records of Mutual Funds?

Later this month, the annual Forbes mutual fund issue will be on the news stands. The focal point each year is on the magazine's "honor roll" of funds which Forbes goes to great lengths to research and present to its readers Their selections are based on a fund's long-term performance through both up and down market cycles. How much credence should you put in the Forbes honor roll, or for that matter, in any one set of recommendations which are based on a fund's performance history of five years or more? Let's find out.

By Austin Pryor

Market gurus come and go because it is impossible to predict future market movements with consistent accuracy. This is one of the reasons that a majority of stock mutual funds have underperformed the general market averages (see "The Winning Ways of Index Funds," SMI May 1995). That's why I devised the Just-the-Basics strategy - it combines rates of return that are better than the average diversified stock fund with modest risk and virtually no upkeep.

If you're not willing to settle for that, your other option is to put together your own portfolio of funds. In making your selections, you are faced with many decisions. How much emphasis should you place on a fund's past performance? How far back is a fund's performance relevant - one year, two, three, five? How will you know when the time has come to sell your fund and move on to something else? How will you know how much risk you're taking? Making these decisions is not easy.

There are many theories about how to pick winning mutual funds. What does that tell you? You don't read theories about why airplanes fly. That's because the laws governing aerodynamics are known and certain. You do read theories on what holds the atom together because it's still a mystery. The point is that no one has yet devised a fool-proof method for selecting next year's top mutual funds. It's an art, not a science. There are no rules you can rely on that will guarantee the result you want. I'm telling you this so you'll have realistic expectations about what you're up against.

In this article, we're going to look at one of the most frequently cited maxims concerning mutual fund selection: You should select funds based on their long-term track records (typically five years is suggested) rather than on who had the hot hand last year. Performance leadership among mutual funds is constantly rotating. The market is so volatile that this year's fund winners may very well be next year's losers, or so the thinking goes. So, rather than focus on a fund's recent history, this point of view suggests that you seek out funds with good long-term records which have proven themselves through many kinds of market environments.

Burton Berry, publisher of a helpful mutual fund ranking newsletter which he calls NoLoad Fund X, performed an interesting study of mutual fund performance. He identified the twenty funds that had the best track records over a recent five-year period and posed this question: how many of these funds will be in the top performing group again next year? The surprising answer was only one. He tried it again for a different five-year period, and the answer was none. Altogether, he checked out twenty-one different five-year periods and found that, on average, only two of the top twenty-five performers of the past five years made the list again the following year.

Well, you might say, isn't it asking too much to expect these funds, which have the best records over the past five years, to be top performers in the sixth year as well? Shouldn't you give them more than just one year to prove themselves? Good point, and one that Berry thought of. He also followed up to see how well the funds did if you held them for five years. For example, of the top twenty-five stock funds in the 1971-1975 period, how many of them were among the top twenty-five for the 1976-1980 period? Only one, which turns out to be about average for all the periods Berry studied between 1966 and 1992.

Berry's work stimulated me to try a slightly different approach. Rather than test to see if a top performing five year record was indicative of a future "top twenty-five" ranking, I tested to see if it was at least indicative of future results that would be better than investing in an S&P 500 index fund. Since I already have my Just-the-Basics strategy in place, the first requirement of any new approach I might adopt is that it surpass my index fund strategy. If it could also be a top twenty-five performer, so much the better. But that would be icing on the cake.

Using the Morningstar database, I structured my test with the assumptions that I would only be investing in no loads, and that I didn't want to have to spread my investments over more than ten funds. Starting with the 1976-1980 period (which is as far back as the data went), I ranked the diversified stock funds according to their five-year track records. Next, I selected the top ten performers, and calculated their returns for the 1981-1985 holding period. I assumed that I divided my investment equally among the ten. Finally, I compared the result with what I would have made in the S&P 500 index fund. The results are shown in the table below. For the eleven periods tested, the portfolio of top performers failed my test nine times. The two periods that passed are in green. Thus, funds selected this way couldn't even meet the less demanding standard of simply outperforming a passive index fund.


Source: Morningstar Mutual Funds Ondisc

Ten top performing were taken from this five-year period Their average annual performance during this period The funds were then held during this five-year period Their average annual performance during this period Performance of S&P 500 index fund during this period How much better did the top-performers do than the S&P 500?
1976-1980 36.0% 1981-1985 12.0% 14.2% -2.2%
1977-1981 28.4% 1982-1986 15.5% 19.3% -3.8%
1978-1982 30.1% 1983-1987 12.6% 15.9% -3.3%
1979-1983 30.0% 1984-1988 10.3% 14.9% -4.6%
1980-1984 22.3% 1985-1989 17.6% 19.9% -2.3%
1981-1985 22.0% 1986-1990 09.2% 12.8% -3.6%
1982-1986 23.9% 1987-1991 12.2% 15.0% -2.8%
1983-1987 19.2% 1988-1992 14.3% 15.6% -1.3%
1984-1988 17.2% 1989-1993 13.4% 14.3% -0.9%
1985-1989 22.6% 1990-1994 10.3% 08.5% 1.8%
1986-1990 15.0% 1991-1995 20.8% 16.4% 4.4%

As an afterthought, I went back and performed the same test with the top five funds from each period rather than the top ten. Perhaps if I stayed with the very best ones, I'd have better results. This approach turned out to be slightly worse than using all ten funds. In addition to my research and that of Berry, the uselessness of five-year performance histories as guides to future performance has also been reported in articles in Investment Vision (June 1991) and Worth (November 1994).


Forbes magazine is well-known for its annual "honor roll" of mutual funds. Publishing such a list has been an annual practice at Forbes dating back to 1973. In assembling its annual list, the magazine does some heavy-duty number crunching. Their process takes into account how funds have done in past market cycles, emphasizing a fund's performance in both up and down markets. This requires looking at performance data that may go as far back as ten years. They also apply several other criteria which they believe are relevant to investors. (I won't include them here because they change their "rules" every few years.)

In the introduction to its September 1989 list, Forbes offers this haughty we-know-what's-best lead-in:

"This list of first-class stock funds isn't at all like a list of the best gainers over the past five years. Good performance is a little more subtle than that .... We consider the simpleminded straightline measurements used by most surveys to be virtually worthless. ... To get on the Forbes honor roll, a fund had to deliver excellent long-term results and do so without exposing investors to excessive risk .... It is hard to get on, harder still to stay on."

Forbes's goal is to select funds which can be bought and held for several years, through good times and bad. In its 1991 annual mutual fund issue, Forbes suggests that "this year's hot performer will be next year's laggard." But instead of acknowledging that some on-going routine maintenance is therefore necessary to keep your portfolio running smoothly, they lead you on a search for all-weather performers that you can supposedly buy and forget about.

Unfortunately, the results simply don't produce as advertised. In the table below, I've listed the results of a study I performed on the Forbes honor roll funds over a wide variety of time periods. For purposes of my test, I assumed that (1) an investor divided his capital equally among the diversified U.S. stock funds some load, some no-load - on the honor roll; (2) the investment was made on the last day of the year; (3) the portfolio was held for periods of one year, three years, or five years; and (4) because the goal was to compare the returns with those turned in by the S&P 500 index fund used in my Just-the-Basics strategy, international funds, balanced funds, and closed-end funds which may have been listed on the honor roll were excluded.

I performed the test ten times; that is, on ten different honor roll lists - beginning with the honor roll of August 1981. The instances in which the honor roll funds, as a group, were superior to the Vanguard index fund are in green. As you can see, Forbes's approach proved superior in only nine out of the thirty time frames tested. In other words, more than two-thirds of the time, some of the best portfolio managers in the country (according to Forbes) failed to produce better returns than an unmanaged index fund. Is this supposed to be outstanding and sophisticated fund selection?

The Technique Behind The Forbes Honor Roll
Also Isn't Predictive

Source: Morningstar Mutual Funds Ondisc

Date Recommended in Forbes 8/81 8/82 8/83 8/84 9/85 9/86 9/87 9/88 9/89 9/90
Following Year 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
Average performance of Honor Roll funds the following year 28.2% 24.6% -5.5% 27.4% 12.6% 3.7% 15.5% 28.3% -5.4% 33.0%
Performance of S&P 500 index fund the following year 21.0% 21.3% 6.2% 31.2% 18.1% 4.7% 16.2% 31.4% -3.3% 30.2%
Superiority of the Forbes Honor Roll vs the S&P 500 index fund 7.2% 3.3% -11.7% -3.8% -5.5% -1.0% -0.7% -3.1% -2.1% 2.8%
Following Three Years 82-84 83-85 84-86 85-87 86-88 87-89 88-90 89-91 90-92 91-93
Average annual performance of Honor Roll the following 3 years 14.9% 16.5% 9.5% 14.1% 10.1% 14.6% 10.9% 19.1% 11.2% 17.4%
Average annual performance of S&P 500 the following 3 years 15.9% 19.1% 18.1% 17.5% 12.8% 16.9% 13.9% 18.3% 10.6% 15.4%
Superiority of the Forbes Honor Roll vs the S&P 500 index fund -1.0% -2.6% -8.6% -3.4% -2.7% -2.3% -3.0% 0.8% 0.6% 2.0%
Following Five Years 82-86 83-87 84-88 85-89 86-90 87-91 88-92 89-93 90-94 91-95
Average annual performance of Honor Roll the following 5 years 16.9% 13.7% 9.5% 17.4% 9.5% 14.9% 15.0% 16.3% 9.2% 16.5%
Average annual performance of S&P 500 the following 5 years 19.3% 15.9% 14.9% 19.9% 12.8% 15.0% 15.6% 14.3% 8.5% 16.4%
Superiority of the Forbes Honor Roll vs the S&P 500 index fund -2.4% -2.2% -5.4% -2.5% -3.1% -0.1% -0.6% 2.0% 0.7% 0.1%

The table does not reflect the loads charged by some of the honor roll funds, thus an investor's actual experience would have been even worse. With the addition of the loads, the honor roll portfolios outperformed the no-load Vanguard index fund only in three instances - only 10% of the time frames tested. The average margin of superiority for the index fund approach was a hefty 6.5% for a one year holding period due to the dramatic effects of paying the sales commission. When the costs of the loads is spread over several years, their burden is gradually lessened. Even so, the average annual margin of superiority for Vanguard's "no-brainer" S&P 500 index fund was 3.6% for the average three-year holding period, and 2.3% for the average five-year period.

In the 1994 honor roll issue, Forbes conceded (for the first time that I'm aware of that "Tough though it is to make the honor roll, we make only modest claims for its predictive power." They should have started the article with that admission rather than with another of their slams at the "run-of-the-mill surveys" published by competing magazines.

The moral is this: don't look down on an investment strategy just because it's simple and straightforward. The way Forbes makes its honor roll selections is so complicated and time-consuming that you could never do it on your own. They tend to give the impression that investing is so complicated and difficult- a kind of first cousin to quantum physics - that you need experts (like them) to constantly guide you. Well, it's not and you don't. All you really need is a prudent, understandable plan and a reasonable amount of self-discipline. "Sophisticated" approaches aren't necessarily more effective.

P.S. Despite what you might think from my assessment of their annual mutual fund honor roll, Forbes is my favorite financial/ investing magazine. It has interesting and informative articles on a broad range of topics. The regular investing columns which appear in the back, including Mark Hulbert's, are worth the price of admission.

Excerpted from Sound Mind Investing, A Step-by-Step Guide to Financial Stability & Growth As We Move Toward the Year 2000 by Austin Pryor (to be released in October 1996). Copyright © 1996 by Austin Pryor. Published by Moody Press.