If you wanted to find the ideal mutual fund to buy today, you could sum up the search pretty easily: You’re looking for an issue that has delivered above-average returns with below-average risk.
It sounds easy, but it’s not only easy to find those issues; it can be hard to actually buy them when you do.
For proof, consider a study issued recently by Todd Rosenbluth, director of ETF & Mutual Fund Research at S&P Capital IQ that focused on large-cap funds that have modest risk profiles.
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The idea behind the study was simple: S&P Capital IQ’s analysts believe the market is due for a pullback, and right quick, which means that the investment environment is changing from one where investors were well paid for taking more risks to one where shareholders will benefit from reducing the chances they take.
There’s little doubt that the funds that have done the best over the last three years have taken on big risks to achieve their big rewards.
The S&P Capital IQ study showed nearly 400 large-cap core funds that outperformed their peers over the last three years but noted that 19 of the top 20 performers had standard deviations above the average peer.
Without getting too technical, standard deviation is a statistical measurement that examines historical volatility, so that a volatile fund will have a high standard deviation, while a more stable fund will measure out at a lower level.
The bigger the deviation, the more the return of the fund is deviating from expected norms for the group; standard deviation helps you in up markets and hurts you in down ones.
Thus, the funds with the best records for the last few years — when the market has seen bullish conditions — were taking big risks.
Anticipating a coming downturn, Rosenbluth wanted to see “who had done well without taking on that risk, who could be good stewards in times of volatility where you could also stick with them when things move higher again or if the market doesn’t have that pullback right now.”
He was looking for risk-adjusted performance, a measure that is commonly used in fund evaluations; Morningstar’s star ratings, for example, are a measure of risk-adjusted return.
S&P Capital IQ also uses a five-star system, though it is based on underlying holdings and costs, so Rosenbluth looked for five-star funds with low standard deviations that had a three-year annualized average return north of 13.5 percent.
The list is a mix of names most investors might have heard from — PRIMECAP Odyssey Stock (POSKX) or T. Rowe Price Capital Opportunity (PRCOX) spring to mind — it also has a bunch of names even a fund junkie like Rosenbluth may not recognize, names like Pear Tree Quality (USBOX) or Golub Group Equity (GGEFX).
In fact, when Rosenbluth opted to highlight the three funds with the lowest deviations, he included the Torray Fund (TORYX), which he owned up to not being familiar with.
The other two included American Funds Washington Mutual Investors (AWSHX) — a fund most industry watchers feel has grown so big that it’s not particularly effective any more — and Weitz Value (WVALX).
Clearly, the research gives an investor a strong case for buying the funds, but Rosenbluth noted that doesn’t mean most investors would ever pick those funds on their own.
Indeed, the evidence is obvious.
For starters roughly 95 percent of all moneys flowing into mutual funds goes into issues carrying Morningstar’s four- and five-star ratings, and not a single one of the funds I have heretofore mentioned here carries a five-star rating, and most earn just three stars.
In short, Morningstar thinks that these funds, for the most part, either aren’t taking sufficient risk or they aren’t delivering enough reward compared to top peers.
Turn instead to Lipper ’s fund rankings, and the top funds from S&P Capital IQ mostly get their top marks for “preservation of capital” — as would be expected — but fall into lesser categories for total return.
That leaves investors with a choice if they are looking for funds right now; buy the one that protects you from a downturn that may be coming, but which has not yet arrived, or buy the issue with the best performance numbers.
No matter how much experts try to educate investors, performance wins every time.
“It is hard to see the market we have been in the last three years and not choose the hottest performers for that new fund to buy now,” Rosenbluth acknowledged.
“It’s the same peer group, the same market and one did better than the other. … Just because you say you want below-average risk/above-average returns doesn’t mean you can buy the fund that the numbers say is ideal for you.
“Even if our timing is wrong, the market will pull back at some point,” Rosenbluth said.
“If you are risk-conscious and a 10 percent decline in the market is going to keep you concerned about your retirement, then you should not be in a fund that is going to decline 10 percent in line with the broader market, but that’s easy to say and a lot harder for someone to actually do.”
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at firstname.lastname@example.org or at P.O. Box 70, Cohasset, MA 02025-0070.
Copyright 2014, MarketWatch