Predicting the future a dicey business

Mutual funds

April 25, 1999|By Bill Barnhart | Bill Barnhart,CHICAGO TRIBUNE

For more than 30 years, the Value Line Investment Survey's "timeliness" recommendations on stocks have been so well followed that they have become self-fulfilling prophecies.

Five years ago, Value Line launched a mutual fund rating service designed to compete with such firms as Chicago-based Morningstar, New York-based Lipper and Maryland-based CDA Weisenberger.

With five years of data on nearly 3,000 equity funds in hand, Value Line recently made a provocative claim: Its fund rankings "have consistently and successfully predicted those funds' performance."

None of the other fund-ranking services has ever claimed that its research predicts the future. In the world of investing, it is a quantum leap from describing past performance and comparing investments to predicting future returns. A standard disclaimer in most investment advertising says past performance is no guarantee of future results.

You can make a case that, at least in the short run, top-performing stocks will attract investors and achieve higher share prices based simply on supply and demand for the shares. But the same cannot be said of equity mutual funds, whose value depends on the performance of an array of stocks. A rush of cash into popular funds often impedes investment returns.

Nonetheless, Samuel Eisenstadt, Value Line's research chairman, and Stephen Savage, director of mutual fund publishing, say the same price-momentum theory that Value Line applies when ranking stocks can be applied when ranking funds. Value Line assigns a rank of 1 through 4 to the funds it tracks, based on each fund's performance over the latest one year, three years and five years. Each fund's rank is adjusted every six months.

"We now have five years of experience," Eisenstadt said. "There is discriminating ability." Group 1 funds posted an average annual return of 17.1 percent over the past five years, more than 50 percent better than the 11.2 percent for Group 4 funds.

But, because the composition of the four ranking groups is adjusted every six months, the claim of predictability merely states the obvious: A group of above-average funds is above average.

Funds that fail to perform drop in the ranking at the next six-month review, assuring that Value Line's No. 1 cohort always outperforms the average of funds tracked. But investors buy funds, not a Value Line-defined group of funds reconfigured every six months. A fund ranked No. 1 today may be ranked No. 4 in a year.

On the other hand, selecting funds that have survived as No. 1-ranked funds over time in the Value Line survey can be a useful preliminary screening technique for investors, for two reasons: First, "We pay less attention to the magnitudes of outperformance and more to the persistence of outperformance," Eisenstadt said. A fund with a spectacular return in 1995, for example, might have ho-hum annual returns in 1998 and 1996. But the average annual five-year return could be extraordinary, dominated by the 1995 result. Value Line's methodology -- looking at one, three and five years -- weeds out the risky shooting stars.

Second, a five-year time frame makes sense in today's volatile stock market and mutual fund industry.

Knowing that a fund has achieved superior compounded annual returns over 10 or 15 years is comforting information for long-term holders of the fund. But a long-term track record has less value for someone selecting a fund for the first time, because a new investor, of course, does not receive the compounded past returns.

"One-, three- and five-year periods are more nimble," Savage said. Over a five-year period, the momentum of a consistently top-ranked fund implies superior performance at least in the near term for new investors as well as long-term holders.

Value Line endorses the significance of short-term momentum in stock prices and mutual fund net asset values. Does that mean a mutual fund consisting of stocks ranking highly in the Value Line stock survey is a sure-fire winner?

Maybe, but it would be hard to pick such a fund, Savage said. That's because funds must report their stock holdings only twice a year, with as much as a 60-day lag.

"Given that the timeliness ranking for stocks is looking at a six- to 12-month window, much of the predictive value of the timeliness rank could be eaten up by the time the mutual fund holdings are released," he said.

Moreover, many stocks in a diversified mutual fund are unlikely to be among the 1,700 stocks Value Line ranks in its timeliness survey.

Pub Date: 4/25/99

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