What a Fund's Annual Returns Can Tell You

• By David Kathman, CFA
• On 7:00 am EDT, Monday September 21, 2009

There's a lot of information available about mutual funds these days, so much that it's easy to feel overwhelmed. One of our jobs at Morningstar is helping investors make sense of all that information. Back in early August, I explained how the new Morningstar.com Quote page brings together the most important fund data in one place, and more recently I outlined five key questions that Morningstar fund analysts ask when they begin to analyze a fund.

Naturally, all this is just a starting point. One useful and relatively simple way to dig deeper, mentioned in passing in the above two articles, is to look at a fund's annual percentile rankings in its category. These rankings can tell you a surprisingly large amount about what type of fund you're dealing with, if you know what to look for.

The Basics of Annual Returns
Each fund's Performance page on Morningstar.com shows its annual returns and annual percentile rankings in its category for each year since 2002. These rankings range from 1 (best) to 100 (worst), with 50 being the median. If these numbers are mostly below 50, then the fund has consistently beaten its category peers, and numbers under 25, representing top-quartile returns, are especially nice to see. Even the best funds don't land in their category's top quartile every single year, but a few, such as Fairholme (NASDAQ:FAIRX - News) (whose annual percentile rankings you can see here), have come pretty close in recent years.

At the other end of the spectrum are funds that have consistently trailed their category, with rankings above 50 and approaching 100. Funds with consistently poor rankings over many years are actually not all that common, as they tend to get merged away or liquidated if their fortunes don't improve. However, it's not too unusual for even prominent funds to go through several years of terrible relative returns; one example is the $6.5 billion Fidelity Growth & Income (NASDAQ:FGRIX - News), whose recent history you can see here.

Most funds are somewhere between these extremes. Plenty of funds have annual rankings that hover around the middle of the pack (between 35 and 65). Most index funds are like this (for example, see Vanguard 500 Index (NASDAQ:VFINX - News) here), as are many index-hugging funds. A fund like this is generally an average fund in its category; not great, not terrible, but unlikely to offer too many surprises. Costs become paramount for such funds, which is why we generally prefer cheap index funds to more expensive actively managed funds with very similar records.

However, there are also plenty of funds that seldom rank in their category's top quartile, let alone its top decile, but still achieve excellent long-term records by being consistently above average. Sentinel Common Stock (NASDAQ:SENCX - News) (see here) is one example of this type of fund; others include many funds in T. Rowe Price's lineup, such as T. Rowe Price Equity Income (NASDAQ:PRFDX - News) (see here), and actively managed Vanguard funds, such as Vanguard International Growth (NASDAQ:VWIGX - News) (see here). These examples show that it's not a good idea to get too hung up on finding funds with top-decile returns in a given year; consistency is also very important, and funds with results that are steadily good (but seldom spectacular) may be a better choice for many investors.

Making Sense of Ups and Downs
There are plenty of funds out there that aren't as consistent as the above examples; their relative returns vary from year to year, sometimes dramatically. Fairholme is one example. As we saw above, it has ranked in the large-blend category's top quartile almost every year since its inception, but in 2003 Fairholme trailed 92% of its category peers. It's not unusual to see this kind of disparity, even in the best funds, because outperforming one's peers requires being willing to look different, and that doesn't always work out in the short term. That's what happened to Fairholme in 2003, when the fund gained 24% but couldn't keep up in that year's speculative bull market due to its lack of technology and other aggressive stocks. Fairholme is not alone, either; of the other large-blend funds whose five-year returns rank in the category's top 1%, Janus Contrarian (NASDAQ:JSVAX - News) trailed 96% of the category in 2008, and Eaton Vance Dividend Builder (NASDAQ:EVTMX - News) trails 97% of the category for the year to date through Sept. 17, 2009.

Patterns of annual outperformance and underperformance can tell you a lot about what kind of fund you're looking at. If a stock fund ranked near the top of its category in speculative bull markets like those of 2003 and the first half of 2009 but got hammered in a bear market like 2008, it's probably fairly aggressive; on the other hand, if it has trailed in bull markets but held up well in 2008, it's probably relatively conservative.

Janus Contrarian, whose annual returns and rankings you can see here, is an example of the first type. The bold strategy of manager David Decker led to top-decile returns each year from 2003 through 2007 but caused the fund to underperform dramatically in last year's market crash, just as it has underperformed in the bear-market year of 2002. In sharp contrast, Jensen (NASDAQ:JENSX - News) (whose annual returns and rankings you can see here) is a cautious growth fund whose managers put a lot of emphasis on cash flows and economic moats. It badly trailed the large-growth category in four of the five years from 2003 through 2007, but it was among the category's best performers in the downturns of 2002 and 2008. True to form, the two funds are performing very differently in this year's speculative rally; as of September 21, Janus Contrarian is back in the top 10% of large-blend funds for the year to date, while Jensen trails 89% of large-growth funds. Both of them are 4-star funds with strong long-term records, but their patterns of annual performance could not be more different.

Any time you see such performance extremes, it's a good idea to dig deeper in order to understand what's behind them. If you're worried about downside risk, a fund that held up well in 2008 might be a good option, even if it has trailed this year. (Funds with high average moat ratings, which you can read about here, fit this bill nicely.) If you have a long-term perspective and don't mind some volatility, a fund that underperformed in 2008 but still has good long-term returns might be a better option. Or it might be a good idea to have both types of funds in your portfolio for diversification purposes; if you owned both Janus Contrarian and Jensen, your returns over the past two years would have been smoother than if you owned either of them by itself. A few funds, such as Fairholme, have done well in both environments recently, but they, too are capable of falling from favor, so it's not a good idea to put too many of your eggs in one basket.

David Kathman, CFA does not own shares in any of the securities mentioned above.

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