Know When To Avoid Following The Leader

MANY investors will pay close attention to the year-end performance rankings appearing over the next couple of weeks. It’s not clear, however, that anyone should change their portfolios because of them.

Consider the performance of a portfolio that each Jan. 1 moved all its holdings into the investment newsletter portfolio with the best return the previous calendar year. Over the almost 17 years from 1991 through November 2007, this annually updated all-star portfolio would have had awful losses — amounting to an annualized decline of 24.2 percent, according to data compiled by the Hulbert Financial Digest. Over the same period, the Standard & Poor’s 500-stock index, including dividends, produced a gain of 11.5 percent, annualized.

The atrocious results of the all-star portfolio certainly suggest that one-year rankings are a very poor guide for investing. But is it possible that the experiences of these top-performing newsletter portfolios aren’t applicable to mutual funds and other popular investment vehicles? It’s worth asking, because a number of academic studies have found encouraging results for a strategy that simply switches every Jan. 1 into the previous year’s top-performing mutual funds.

One such study was conducted in the mid-1990s by Mark Carhart, who was then at the University of Southern California and is now co-head of quantitative investment strategies at Goldman Sachs Asset Management. He built a hypothetical portfolio that invested each year in the 10 percent of diversified domestic equity funds with the best returns from the previous calendar year. From 1963 through 1993, according to his calculations, this portfolio outperformed the overall market by an annual average of more than eight percentage points. These calculations, however, don’t reflect the impact of front-end loads (sales charges) and redemption fees, so the portfolio’s real-world return would have been lower. (His study, “On Persistence in Mutual Fund Performance,” was in the March 1997 issue of the Journal of Finance.)

Impressive as this portfolio’s returns have been, some researchers say its performance isn’t good enough to justify using it as a basis for investing. That’s because it has tended to be much riskier than the overall stock market.

Mr. Carhart’s own findings illustrate the heightened risk of investing in a previous year’s top performers. There is a below-average chance, he found, that a given year’s top fund will be in the middle of the pack in the next year’s ranking. In other words, when top funds are winners in that following year, they tend to win big; but when they aren’t, they tend to incur big losses.

To be sure, plenty of top-performing funds do well in consecutive years, and they tend to be prominently advertised by the companies that run them. But there are also many negative examples. Consider the top-performing diversified domestic equity fund of 1999, the Van Wagoner Emerging Growth fund, which gained 237 percent that year. In 2000, however, it lost 20.9 percent. A similar reversal occurred in 2003, when the Prudent Bear fund lost 10.4 percent after leading the performance list in 2002, with a gain of 62.9 percent.

Such shifts from spectacular gains to big losses don’t happen every year, but they occur with some frequency — especially when the overall market changes direction or as investment styles go in and out of favor.

The bottom line is this: Read the lists of top performers as much as you like, but unless you are a risk taker, don’t rely on them for your investments.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.

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