Past performance does not guarantee future results, as all mutual fund advertising cautions. In fact, when a bull market begins, you may fare best with funds that performed miserably in the bear market just before it.
Consider the 100 domestic equity funds that performed the worst during 2002, the last year of a bear market. Their average loss that year was 53.3 percent, according to Morningstar — more than double the 20.9 percent loss of the overall stock market, as measured by the Dow Jones Wilshire 5000.
In 2003, the first year of the subsequent bull market, those funds were among the best performers. They gained an average of 60.3 percent, compared with “just” 31.6 percent for the market as a whole.
This reversal of fortunes between 2002 and 2003 could have been expected, according to Russ Wermers, a finance professor at the Smith School of Business as the University of Maryland. In an interview, he said that the funds that lost the most during market declines tended to be quite risky. Of course, this risk tends to work against them during declines — but often bolsters their performance when the market rises. This is part of the reason that a new bull market causes fund rankings to be turned upside down.
In his research, Professor Wermers has found that another big part of the explanation is the changing fortunes of various stock sectors as the market’s overall trend shifts. Funds that bet on a sector that did well in a market downturn, for example, tend to do poorly when the market rises, he said.
His findings help to explain why Morningstar’s star-rating system has great difficulty in the early stages of a new bull market. The firm bases its star rating for a given fund on how it compares with others having a similar investment style.
Consider two hypothetical portfolios of mutual funds constructed according to their Morningstar ratings at the end of the 2000-02 bear market. The first contained all domestic equity funds that, at that time, had a one-star rating (Morningstar’s lowest); the second contained all those with a five-star rating (the highest).
In 2003, the first portfolio produced a return almost five percentage points higher than the second, according to an analysis that Morningstar conducted for Sunday Business. That’s the opposite of what an investor might have expected by using Morningstar’s ratings to pick funds at the beginning of that bull market.
These reversals stand out because they are the exception to the rule. So long as stock market’s major trend is not in transition, Professor Wermers has found, there is a modest amount of persistence in funds’ year-to-year rankings.
Similarly, Russel Kinnel, Morningstar’s director of fund research, reports that since 2002, when Morningstar adopted its current fund rating method, the average five-star fund has outperformed the average one-star fund over the year after the funds received their ratings.
The investment implication of these results depends on whether you choose funds on the basis of recent returns. If you do, Professor Wermers argues, you should at least temporarily stop doing so whenever you think stocks’ general trend may be about to shift from down to up.
But that doesn’t mean you should ignore all past performance at the beginning of a bull market, he added. After all, it is only the funds’ returns during the preceding decline that are a particularly poor guide. At such times, he said, you should instead look back at periods much longer than the previous year or two.
How far back to go? There is no consistent answer, he said, because the period needs to be long enough not to be dominated by any bear market years. Ten years might be enough in some cases, but right now the period should probably be even longer, because the stock market is lower today than it was 10 years ago.
His advice presents a particular challenge to fund investors who rely on Morningstar’s ratings, because a fund’s overall star rating is heavily influenced by its recent performance. Morningstar does calculate a separate rating based on a fund’s performance over the last 10 years; it is available on the firm’s Web site. But even that longer-term rating is less than optimal now.
Even better, Professor Wermers added, would be a rating “conditioned on the current state of the economy,” such as a “5-star bear-market fund” or a “5-star bull market fund.”
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