Whether you're picking mutual funds or investment newsletters, last year's performance is worse than worthless. Focus on long-term performance -- ten years is best. Investment newsletter guru Mark Hulbert shows you why. By Steven Goldberg, Contributing Columnist August 15, 2006 When you're picking investment newsletters, ignore short-term performance. Instead, focus on how the newsletter has done over the long haul. Ten-year performance is ideal. What's more, past risk-adjusted returns are better predictors of future newsletter performance than are just raw past results. We know both of those things thanks to Mark Hulbert, who for the past 26 years has published the Hulbert Financial Digest. Hulbert's painstaking work yields important guidelines on how to pick newsletters that are likely to excel. I think his work can be extrapolated to help in picking good mutual funds, too. Hulbert's newsletter analysis For his anniversary issue, Hulbert crunched the numbers on past newsletter performance three dozen ways. Using varying methods, he calculated returns over the 15 -and-a-half-year period beginning at the start of 1991. The starting date represents the point at which Hulbert first had ten years of data. Hulbert employed a variety of methods to see what factors best predict winners. For instance, he used one rule that called for picking the top performer over the previous year and holding it for a year. He employed another that called for selecting the top one-year performer and holding it until it dropped out of the top five. Then he averaged all these different approaches. His conclusions are fascinating. The worst way to pick a newsletter is to pay attention to the previous year's performance. Over the past 15 and a half years, you would have lost an annualized 13% by focusing on one-year performance. Your money would have essentially been wiped out following such strategies. By contrast, suppose you selected newsletters based on their performance over the previous ten years. Over the past 15 and a half years, you would have earned an annualized 9%. That still lags the SP 500 by one percentage point per year, on average. But, obviously, concentrating on ten-year winners is better than focusing on one-year winners. What about shorter periods, such as three years and five years? The longer time period you consider, the better. Focusing on five-year winners would have earned you an annualized 7%. Three-year winners would have lost you an annualized 1%. Hulbert then divided all 36 of his methods of picking winners into those that focused only on past returns and those that employed risk-adjusted past returns. The average of the risk-adjusted return methodologies gained 3% annualized; the average of the past returns lost an annualized 2%. In short: risk-adjusted performance is a better predictor of future results than performance alone -- but not by the same margin that long-term performance beats short-term performance. How do you compute risk-adjusted returns? You take past returns and adjust them according to how much those returns bounce around month to month (the volatility). Sharpe ratios give you one kind of risk-adjusted returns. What it means for mutual funds How does all this apply to mutual funds? Tune out one-year returns -- which, of course, is so difficult to actually do, particularly if you already own the fund. Three-year returns are little better. Five-year returns begin to have some meaning, and ten-year returns are valuable. Remember, of course, both with newsletters and mutual funds, that all these numbers can be meaningless unless the same person remains at the helm. (Not always: Sometimes a newsletter editor or fund manager inherits an essentially mechanical strategy and can execute it just as his or her predecessor did.) What's more, a mutual fund can lose its edge if it is so successful that it attracts a ton of money, and a newsletter can falter if too many dollars follow the same strategy. Hulbert tries to remain an impartial umpire, so his main work is crunching numbers. But I'm not under any such constraints. So I try to use judgment in analyzing funds and newsletters. Does the editor/fund manager display a passion for what he's doing, or is he just trying to make money for himself? Does the editor/fund manager seem to know what he's doing or did he just get lucky? Does he have a discipline that he sticks with through thick and thin? Top-performing newsletters On a risk-adjusted basis, the top-performing newsletter over the past ten years is No-Load Fund*X (www.fundx.com), which switches among funds that have been top performers over short periods of time. No. 2 is Investment Quality Trends (www.iqtrends.com), which recommends stocks whose dividend yields are higher than they have been historically. And No. 3 is No-Load Mutual Fund Selections Timing (www.investmentst.com), which employs a combination of technical and fundamental analysis. Are any of these letters for you? Generally, I prefer a long-term, buy-and-hold approach when investing in mutual funds. What's more, all these newsletters cost a bundle -- all of which comes off the top of your profits. But Investment Quality Trends is a relatively good way to pick large-company stocks. And No-Load Fund*X is a good bet -- if you have the time, energy and discipline -- to use in a tax-deferred account. Steve Goldberg is a freelance writer and former senior associate editor of Kiplinger's Personal Finance magazine.