Beware of One-Year Returns

Investing in a fund because it has delivered spectacular gains over the past year is always a lousy idea. But it’s an especially hazardous strategy now, thanks to the stock market’s huge rally since bottoming in March 2009.

Consider the top-performing fund over the past year through March 22: Birmiwal Oasis (symbol BIRMX) skyrocketed 224% over the period. That’s more than four times the 55% return of Standard & Poor’s 500-stock index.

Birmiwal, which is closed to new investors, has a terrific record. Over the past five years, it has earned an annualized 16%. But it is one of the most volatile funds I’ve ever seen. From month to month, Birmiwal’s returns bounce around more than 2.5 times as much as the S&P 500’s returns do. The fund has big stakes in stocks of tiny companies. Turnover the past year was an astonishing 999% -- meaning that on average the fund held stocks for not much longer than a month. Birmiwal plunged a breathtaking 63% in 2008. Clearly, what goes up a lot can also go down a lot.

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But short-term performance sells. Investors pile into funds after they’ve had a great year. Fund companies know this and advertise funds that have done well lately. Moreover, the media tend to focus on funds that have just shot the lights out. Who wants to read about a fund that lost money last year?

However, one-year returns don’t tell you a thing about how a fund will do next year -- after you’ve placed your hard-earned money into it. Indeed, after a hot streak, a fund may well experience a period of subpar returns.

In the number-two slot over the past 12 months is Direxion Monthly Small Cap Bull 2x (DXRLX), which soared 217%. This fund aims to provide twice the return of the Russell 2000 small-company index on a monthly basis (the fund had sought to return 250% of the index’s return on a daily basis, but last September it changed its objective). But daily and monthly returns aren’t the same thing as annual returns. In 2009, for instance, the Russell 2000 gained 27% for the year while the Direxion fund rose 40% -- far short of twice the index. And in 2008, the Russell lost 34%, but the Direxion fund lost 78% -- ten percentage points more than double the Russell’s loss.

So if you’re bullish on small-company stocks and you have a reliable Ouija board, the Direxion fund is for you. Otherwise, stay far, far away from this fund and all other leveraged mutual funds and exchange-traded funds (see These Funds Can Be Hazardous to Your Wealth).

Fidelity Select Automotive (FSAVX) returned 201% over the past 12 months, finishing in third place (see Why a Car Fund Took Off). Auto stocks, however, were simply rebounding from the shellacking they took in the bear market that began October 9, 2007. This fund shed 61% in 2008 alone. Indeed, Fidelity Select Automotive is every bit as volatile as Birmiwal. Funds that invest in single industries are seldom good investments. Why pay good money (in the form of annual expenses) for a fund and then tie the manager’s hands?

Volatile funds like these come with special risks. Remember, you lose more when a fund drops in percentage terms than you gain when it rises by the same percentage. Say you start with $100 and lose 40%. You now have $60. Gain 40% and you now have $84. The bigger the percentage loss, the worse damage this arithmetic does to your portfolio. That’s why you should put only a small amount of your money into super-volatile funds and use them with extreme caution.

Short-term returns are of no value in assessing a fund’s worth. Any fund manager can get lucky for 12 months. And academic research shows that three-year and even five-year returns are still of little or no value in judging the quality of a fund. Go further back -- ten-year returns do have some predictive ability, in my view.

The past two years have been extreme -- first with the market selling off far more than the fundamentals warranted, and then with a sharp rebound that, in many instances, simply corrected the exaggerated decline. For that reason, I think it’s particularly difficult to find much value in recent returns. In any event, don’t look only at past returns when you’re buying a fund -- and be especially skeptical of one-year results.

Steven T. Goldberg is an investment adviser in the Washington, D.C., area.