"Three questions to ask of a top-performing mutual fund"

A few days ago, I asked if you were on the outside looking in as the market continues its long and steady advance. If so, you're not alone. MarketWatch writer Chuck Jaffe points out that while the S&P 500 is up about 50% over the past year (from 3/31/09 through 3/31/10), relatively few investors have been along for the ride.

Jaffe provides data to support the premise that too many investors wait until there's been a solid year of gains before they come to believe that the worst is over and muster the courage to re-establish their stock positions. Since we're at that point now, Jaffe offers a warning:

Any decision to come back after strong 12-month results may be too little and too late. Accordingly, investors should understand what makes some funds shoot to the top of their peer group over a one-year stretch, and why some of those 12-month numbers are particularly misleading and dangerous....

Here are three questions to ask when considering a fund that has vaulted to the top of the performance charts...

Jaffe's questions and his related comments (in italics below) are worth thinking about - and I want to respond to them from the point of view of SMI's Upgrading strategy, which has a long and successful track record of investing in funds that have "vaulted to the top of the performance charts."

1. Is performance repeatable? You can't buy into what the fund did yesterday, so all that matters is what happens next.

Upgraders agree. The question then becomes: What clues do we have as to what will happen next? There's a significant body of research that shows there is a short-term tendency for recent winning performance among mutual funds to persist - that is, performance leaders of the recent past tend to be the performance leaders of the near-term future. SMI's performance-momentum rankings (available to our subscribers and web members) are our attempt to take advantage of this tendency.

2. How did the fund rise to the top? ...Whenever a fund tops its peer group, make sure its investment strategy and style is truly reflective of the larger group; the easiest way to top the short-term charts is to game the system.

Upgraders agree. That's why we separate mutual funds into the various risk categories - to compare, as best we can, apples to apples in terms of manager strategy and style. However, it's also true that as long as a fund continues to do well, we don't mind a little style drift. That might matter to an investor looking to own a fund for years, but is not a concern to Upgraders who own our recommended funds, on average, for less than one year.

3. Are you chasing returns? Investors typically wait to buy until the investment has proven itself with a stretch of good performance. Then the hot run comes to an end, the fund cools, and the investor never gets the stellar performance that drew them in the first place.

Upgraders agree there's a risk here, but one that's manageable. Note that Jaffe says, "the hot run comes to an end." In other words, the investor typically enjoys some degree of success initially. The idea that "the investor never gets the stellar performance that drew them in the first place" reflects the view that the investor has no selling discipline and will be a long-term holder of the fund. We rely on our strict selling guidelines to help prevent holding a fund too long once "the fund cools."

This is why Upgrading has beaten the market in 10 out of the past 11 years.

Learn more about Upgrading and SMI's other time-tested strategies.
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Austin Pryor is the founder and publisher of the Sound Mind Investing newsletter and website. Learn more about Christian investing and finances at the Sound Mind Investing website.