To Michael D. Hirsch, it's ``the trap of performance.'' Just about every fund touts performance in its advertising and sales literature; it's the best way funds have to compare themselves with each other. And yet, says Mr. Hirsch, vice-president and chief investment officer of the Republic National Bank in New York, ``more people get led into the wrong fund by the misuse of this word.'' Hirsch is also the author of ``Multifund Investing'' (Dow Jones-Irwin, Homewood, Ill., $32.50).
That misuse, he says, includes ad headlines that say things like ``Last Year's Top Performer'' or ``Best Performing Fund Five Years in a Row.'' Statements like these, he believes, emphasize ``super'' performance over ``consistent'' performance. Many funds that top the performance charts for one, two, or three years are nowhere to be found later. ``There's almost a 50-50 chance a fund will do poorly after appearing on these lists,'' he notes.
How do you pick a mutual fund, then?
Well, performance is one place to start, though only one. One of the most common performance indicators is total return. Most funds use the example of $10,000 invested at a given time and show what that would be worth now. Total return includes the increase in the net asset value, any capital gains taken as additional shares in the fund, and the reinvestment of all dividend income.
If $10,000 was sent to a fund five years ago, and it is now worth $50,000, the total return represents a gain of 400 percent. But that doesn't take into account any fees or charges that might have been imposed. If the fund had a full 8 percent load, or sales charge, your actual investment would have been $9,150.
Now, a gain to $50,000 appears to be larger, at 446 percent. If, however, you had invested in a no-load fund and had a 446 percent gain, you would have ended up with $54,600. Of course, if you find a load fund with an excellent performance record - and there are several - even an 8 percent load may become insignificant. And a 2 or 3 percent ``low-load'' will seem even less significant if the fund racks up respectable gains.
Even with a no-load fund, however, you will pay a yearly management fee. This is - or should be - a small percentage of assets used to meet salaries, and to give the company its profit.
``Probably anything over 1 percent is excessive,'' says John Markese, director of research at the American Association of Individual Investors.
Sometimes, a fund will compare its performance with the Standard & Poor's 500 index, considered the broadest measure of the largest stocks. The S&P went up a litle over 300 percent from the end of 1975 to the middle of this year, so a fund that claims to ``beat the averages'' is saying it had a total return higher than 300 percent for that period.
But, as Hirsch points out, consistency of performance is more important to long-term investors. In a bull market, lots of portfolio managers do well. They may not all beat the S&P, but their returns are still pretty good compared with more conservative investments like bonds or Treasury bills.
The test comes when the market turns bleak. It may be too much to expect a fund manager to keep making big gains in a long-term bear market, but the best performers manage to hold on to the gains made earlier.
Some publications track the performance of mutual funds in both kinds of markets. For funds with a long enough history, Forbes, for example, annually gives letter grades, A through F, on performance in both up and down markets. The best funds get at least a B in both and end up on the Forbes honor roll.
But Hirsch says that ``there's been tremendous turnover in that list in the last two years. You have to wonder why so few funds stay on the honor roll more than a few years.''
Still, a fund that has modest gains in an up market and holds those gains in a down market will provide better long-term results than a fund that has spectacular gains when stocks are soaring, only to fall way behind later.
Among the funds that have managed to stay on the Forbes list for more than a couple of years are the Amcap Fund, the American Capital Pace Fund, Fidelity's Destiny and Magellan Funds, the Janus Fund, the Nicholas Fund, and Twentieth Century Select Investors.
You can also find performance comparisons in other publications, including Barron's, which publishes a list prepared by Lipper Analytical Services every quarter; Money, which has an annual ranking of mutual funds; and Personal Investor, which also ranks top funds.
Almost as important as performance, Mr. Markese believes, is service. Nearly all funds have a toll-free phone number so you can ask about the fund's performance, dividend payments, and switching privileges.
``They should have other funds you can switch into,'' he says. ``Especially a money market fund.'' This way, if you see the net asset value of your fund dropping too fast for your taste, you can switch all or part of your money into the money fund. Yields on money funds aren't too hot these days - generally about 5 percent - but the net asset value stays constant at $1 a share, so you won't lose anything while waiting for the stock fund to recover, or while you look for another fund.