Mutual Funds' Three-Year Itch

You may have noticed that mutual fund literature is looking snazzier lately. No, not the smiling septuagenarians pictured aboard the yacht -- the all-important three-year returns listed just below.

Mutual fund companies and the agencies that track them generally show four performance figures, all measuring average annual returns: year-to-date, one-year, three-year and five-year. Some funds even offer 10-year numbers.

But because many funds haven't been around even five years, the three-year return has emerged as the de facto fund-performance yardstick. That's a happy coincidence for fund companies, because looking at a fund's three-year performance right now eliminates the ugly showing that so many funds put in in a bleak 2002.

But a quirk of timing that has fund companies sighing with relief should make fund investors beware.

"People tend to focus on three-year returns," says Russell Kinnell, director of fund research at Morningstar. "And this is a good lesson as to how just one year can have a big effect on three-year returns."

Indeed, the reason the industry likes three-year return numbers right now is that 2002, the last big down year for the market, is passing out of view. Over 2000-2002, the S&P 500 lost 9.7%, 11.8% and 21.5% in succession. In 2003 and 2004, though, the index turned around, returning 28.1% and 10.7%, respectively. This year the S&P 500 is up slightly, putting its three-year average return at a pleasant-looking 15.2%.

The five-year average, on the other hand, is about negative 2%.

That swing could trick careless investors into choosing the wrong fund. The average technology fund, for instance, sports a three-year annnual return of a healthy 22%, according to Morningstar. But tack on another two years, and the average annual loss is a staggering 18%.

Likewise, the average specialty communications fund is up 30% over the past three years, but down 11% a year over five. And swing in the average Latin American fund between the three-year and five-year annual return is a hefty 35 percentage points.

In order to reduce bull market bias, Kinnell says fund investors should judge funds on their performances in both bull and bear markets whenever possible. That is, look at both the three-year and the five-year numbers. And for specialty funds, he suggests comparing a portfolio manager's performance against his industry benchmark as well as his peers.

"If you are going to buy a junk bond fund, you need to know how the manager performed when junk bonds got killed," says Kinnell.