Gap between 3- and 5-year fund returns is huge now

BOSTON (AP) ? It’s common advice for selecting a mutual fund: Check its 3-year performance, or better yet the 5-year results. Anything less than that and you risk becoming captive to the short-term thinking that trips up many investors.

Yet these days, anyone reviewing 3- and 5-year numbers might understandably think there’s a misprint.

Take the Pimco Real Estate Real Return Strategy Fund (PETAX). Its average annualized investment return over the latest 3-year period is 44 percent a year. But its more meaningful 5-year average is 2.4 percent a year.

How can the fund’s 3-year figure be nearly 20 times bigger?

It’s all about the calendar. Current 3-year returns don’t cover September and October 2008, the period when stocks took their steepest dive of the financial crisis. But they do incorporate all the recovery that began in March 2009.

Five-year returns look comparatively puny these days ? and many funds posted losses ? because the period includes all of the market’s boom-bust-boom cycle dating to late 2006.

Coming on the heels of the historic financial crisis in 2008, it’s highly unlikely the next three years will follow the same dramatic rise. So resist the temptation to chase those hot 3-year returns, and drop any hopes that future results might resemble those phenomenal figures.

“They ought to have a huge asterisk ? one that comes out and punches you in the nose,” says Daniel Wiener, who runs Adviser Investments, a manager of more than $2 billion for individual investors, and editor of an independent newsletter on Vanguard’s mutual funds. “If you take these 3-year numbers at face value, you can only be disappointed. They’re so out of the realm of anything close to normal that you set yourself up to say, ‘Wait a minute, what happened here?'”

Besides the Pimco fund, Morningstar data show eight funds with 3-year average annualized returns that are at least 40 percentage points greater than their 5-year figures. One even had a nearly 58 percentage point gap: Direxion Monthly Nasdaq-100 Bull 2x (DXQLX), with a nearly 52 percent 3-year average return, and a 5-year loss averaging 6 percent.

That fund employs an alternative investing strategy that helps explain its huge gap. The Pimco fund and many others with large disparities specialize in real estate investments, which have been unusually volatile the past five years, including stocks of real estate investment trusts.

But plenty of broadly diversified stock funds commonly found in 401(k) accounts have big gaps as well. Typical is the $102 billion Vanguard 500 Index (VFINX), which tracks the Standard & Poor’s 500 index. It has an average annualized return of 15.3 percent over three years, but a 0.1 percent loss over five years.

The gap between 3- and 5-year returns will widen further early next year as the three-year anniversary of the stock market bottom on March 9 approaches. The gap will remain unusually large through late 2012, until 3-year returns no longer include the mid-2009 surge in stock prices.

It’s a sort of teachable moment for fund investors. The lesson: Three- and even 5-year returns can create a skewed perspective, especially when they cover periods of market booms, busts, or both.

“Investors tend to emphasize recent performance, but there’s a lot of noise in short-term results,” says Karen Dolan, Morningstar’s director of fund analysis. “It’s hard to know what to do with that information.”

The problem is that 3- and 5-year numbers are snapshots in time that can look vastly different depending on the calendar. Such trailing returns cover a single discrete period that can include the best and worst of market performance during that stretch.

A more balanced picture emerges from rolling returns, covering multiple time frames leading to a specific date. For example, investors might incorrectly think it’s not unusual for the stock market to decline over the course of a decade, based on the nearly 10 percent loss in the S&P 500 from 2000 through 2009, including dividends. But historically, that was rare. On a rolling basis, the S&P 500 has produced losses in only four out of 76 different 10-year periods since 1926, according to a T. Rowe Price analysis.

Mutual funds’ rolling returns are worth examining to supplement trailing returns because they more accurately reflect how people invest. Shareholders deposit money into funds or make withdrawals day in and day out, based on factors that have little to do with the end of the month or year. So their holding periods, and investment performance, cover dates across all parts the calendar.

The problem is that rolling returns are hard and sometimes impossible to find in materials published by fund companies and fund ratings services. Often, they take the easy way out because rolling returns are more complex than trailing returns to illustrate.

For example, a fund that Morningstar recently awarded top-notch ‘gold’ credentials under its newly launched analyst ratings of funds is T. Rowe Price Equity Income (PRFDX). A key consideration was its consistently strong results, based on 3-year rolling returns. In the 26 years Brian Rogers has been managing the fund, the fund’s 3-year returns ranked within the upper half of its fund category more than 75 percent of the time. In 22 percent of those 3-year periods, the fund was in the top 25 percent.

The difficulty of conveying all that in a snappy graphic is a key reason why rolling returns aren’t easy to find on Morningstar’s website, Dolan acknowledges. If you click on a fund page’s “chart” tab, the default will be a “growth” line graph of returns. In the upper-left of the chart you can use a pull-down menu to change the graph to “rolling returns” mode. That will yield rolling return data in a bar graph, but it’s not easy to understand at a glance.

That’s why Morningstar is experimenting with a new rolling return graphic that it hopes to introduce next year. It’s a summary of how frequently a fund has finished within the top quartile among its category peers over 3-year periods, and how often it’s been in the second, third and bottom groupings.

“We hope the new graphic will be an easier way to digest rolling returns,” Dolan says. “At times like now, they’re worth considering, because the trailing returns don’t tell the whole story.”


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