When shopping for new clothes or household goods, how do you decide what to buy? Price is typically an important factor, but so is quality. If you’re familiar with a brand and satisfied with how its products have performed in the past, you’d probably consider buying that brand again in the future.
But when it comes to shopping for mutual funds, past performance is a less helpful indicator of future performance. That’s because it’s difficult to determine whether fund performance is due to the manager’s skill or to sheer luck. Typically, what separates good performance from bad during distinct market periods is how funds differ in their investment style and approach to risk. For example, growth-oriented funds tend to do well when the economy is expanding and suffer during low-growth periods or recessions.
These factors help explain why so few fund managers are able to consistently outperform their peers, says Jim Peterson, Chief Investment Officer at Charles Schwab Investment Advisory, Inc. “Even those managers who are highly skilled may face other obstacles, such as high expense ratios that are difficult to overcome or a success–fueled influx of new assets that spreads returns too thin,” he says.
Jim advises taking a more nuanced view when evaluating mutual funds.
- Consider different return periods. One-year returns can capture momentum in certain sectors, while longer periods are more likely to show a manager’s skill at selecting securities. Looking across multiple time periods can serve as a good gauge of consistency.
- Look at a fund’s portfolio holdings. This can tell you whether the manager is “hugging” or simply copying the fund’s benchmark to keep performance from deteriorating.
- Compare costs. It’s always important to understand how a fund’s expense ratio stacks up against similar funds.
Jim’s team at Charles Schwab Investment Advisory considers all of these factors and more when determining which funds will make the Schwab Mutual Fund OneSource Select List®. The team also employs statistical techniques to help differentiate manager skill from luck. “It feels natural to evaluate mutual funds by past performance,” Jim says, “but we have found that identifying truly skilled managers takes more digging.”