U.S. investors have more than 10,000 mutual funds and ETFs to choose from, and many of them are posting one-year performance numbers that under normal circumstances would make your mouth water. Over the past 12 months, the broad stock market, as measured by the S&P 500, has returned a massive 50%. (That's partially due to the fact that the huge market dip in early 2020 is now more than a year past.)
That rising market tide has lifted a lot of boats. So if you're looking to add a new investment to your portfolio, you'll have to look beyond recent results to determine which funds are likely to be long-term winners, says John Wheeler, a certified financial planner and senior financial consultant at Castle Wealth in Indianapolis, Indiana.
"Focusing on one-year performance is really dangerous," Wheeler says. "If I got into a fund solely because it performed well over the past year, I'd be chasing a rate of return that I'm not guaranteed going forward."
Finding a fund that's appropriate for your long-term goals will require some financial detective work. Here are the top three factors to focus on.
In a year when everyone is doing well, you'll have to dig further into the past to understand which fund's track record truly stands above the rest.
"Take a look at the fund's fact sheet and find the longest time horizon available," says Michael Moriarty, chief investment officer at Wealthspire Advisors. "A 10- or 15-year annualized number will give you a better idea of what you can typically expect."
Still, even the longest-term track records may be skewed by this year's explosive returns. You'll also want to compare a fund's performance to its benchmark index, as well as to peer funds, on a year-by-year basis, favoring funds that consistently outperform. You can find fund performance through the fund's page on your brokerage website, or by checking out publicly available investing research sites such as Morningstar.com.
Pay extra attention to how the fund performed in years when similar investments struggled, says Moriarty. "That's especially true with active managers who are trying to outperform a benchmark," he says. "If the benchmark was down 8% and the fund was down 18%, that's interesting. If [the manager] was down only 5%, that's interesting too."
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Stocks have been on such a tear of late, many investors may have forgotten that what goes up can also come down, says Kimberly Clouse, a partner advisor at AdvicePeriod in Brookline, Massachusetts. "There's volatility to investing in stocks," she says. "And volatility means there's volatility up and volatility down."
Investors gravitate toward funds that offer dazzling returns, but achieving those big numbers often means taking on extra risk to get there, Clouse points out. One sign that a mutual fund or ETF may be prone to big swings in performance: concentration in just a few holdings.
"Ask yourself what percentage of the portfolio is comprised of the [fund's] top 10 holdings," Clouse says. "If it's a big portion of the portfolio, that fund may move a lot based on the performance of a few stocks."
Video by Helen Zhao
To assess a fund's volatility, you can also examine standard deviation, a measure of how far a fund's returns stray from the mean. Consider the Ark Innovation ETF, which returned an annualized 50% over the past three years, compared with a 16% return in the S&P 500. Over the same period, the fund posted a standard deviation of 36, making it about twice as jumpy as the index and its standard deviation of 18. (You can find volatility metrics on Morningstar under any fund's "Risk" tab.)
While that volatility can be thrilling when a fund is on the upswing, sharp portfolio drawdowns can cause many investors to panic and sell low. Moriarty recommends using a quick-and-dirty calculation to determine a fund's potential losses. "Take the standard deviation and multiply by two for a reasonable expectation of a loss," he says. "That doesn't mean it's going to do that every year, but every three, four, five years, you can expect that sort of drawdown to occur."
If two funds have excellent track records — even nearly identical ones — the factor that may separate them over the long run is cost. "If two index funds [both] say that they track the S&P 500, that tells me that there might be a big difference in fees," says Clouse.
Over the course of your career as an investor, even that small difference in fees can add up to a big difference in profits. Consider two funds that seek to replicate the performance of the S&P 500: the Vanguard S&P 500 ETF, which charges an expense ratio of 0.03%, and the Great-West S&P 500 Index mutual fund, which charges 0.52%.
If you invested $10,000 in the Vanguard fund and held it for 40 years, earning an annualized 8%, you'd pay $832 in fees and end up with about $215,000. Had you made the same investment in and earned the same returns from the Great-West fund, you'd only have $176,000 to show for it, and you'd have paid $12,560 in fees.
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