03/22/2011 08:16 pm ET Updated May 25, 2011

The Misguided Search for the "Winning" Mutual Fund

Those people over at Standard & Poors spoil all the fun. Their periodic research reports on the performance of mutual funds routinely show the majority of actively managed mutual funds underperform the benchmark indexes the fund managers are so handsomely paid to beat. As if that indignity was not enough, twice a year they publish the "S&P Persistence Scorecard." It answers the question every active fund manager fears: Does past performance matter?

We all know that "past performance is not an indicator of future performance", but the financial media and the securities industry work seamlessly to convince us this is not true. Here's what I mean:

CNBC has "fund screener" on its web page.. It lets you find funds that have a history of stellar performance. Forbes touts its mutual fund screener that "...will help you find the right pick from our database of more than 2,600 funds that qualify for a Forbes Rating based on their track record in bull and bear markets."

TD Ameritrade lets you select certain criteria, including past performance, and screen for funds that meet your requirements. All of the major brokerage firms offer similar screens.

John Hancock recently launched a massive advertising campaign in which it featured the fact that many of its mutual funds are rated four and five stars by Morningstar. Presumably, the message is that its past performance is an important factor for investors to consider when shopping for mutual funds.

The latest S&P Persistence Scorecard presents irrefutable data indicating that this focus on past performance to predict future performance is simply nonsense.

Let's assume you used one of the fund screeners and identified each one of the 542 domestic stock funds that was in the top twenty-five percent of performers for the first year of the five year period measured by the Persistence Scorecard, commencing in September 2006. You decided to invest in all of them, confident that the majority would repeat their fine performance. After all, fund management is a skill, and these managers clearly had the secret to successful investing, right?

According to the Persistence Scorecard, your fund selections were a total bust. Not a single one of these top performing funds maintained its top quarter ranking in each of the remaining four years.

This is not surprising for those familiar with the data. When a fund outperforms, Wall Street tells you the fund manager has skill. In fact, it is just luck. Skill persists. Luck doesn't. If a fund family had investment skill, all of its funds would outperform the market. It would not be advertising just the few winners.

As investors, you need to screen out mutual fund screens and ignore past performance. Investing based on these factors is harmful to your financial wealth.

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