When the market crash of 2008 fades into history, a lot of mutual funds will look more appealing. But remember, bear markets show what a fund is really made of.
Your stock funds' five-year returns are getting ready to double. Why? It's just a matter of the calendar: By Dec. 31, the stock market's disastrous 37-percent plunge in 2008 will no longer be part of funds' five-year records.
Of course, this calendar quirk won't put more money in your pocket. To the extent you were in stocks in 2008 or over the entire bear market, which sliced 55.3 percent from Standard & Poor's 500-stock index ($INX) from Oct. 9, 2007, through March 9, 2009, you almost certainly lost money -- quite possibly a lot of it.
But dropping '08 from the five-year figures will make a lot of funds look shinier and more appealing -- if you don't look further back than the past five years. Don't make that mistake.
Look at how returns can grow. At the end of August, the five-year annualized return for the S&P 500 was 7.3 percent. If you assume that the market will be absolutely flat from Sept. 1 until the end of this year (an approach I borrowed from Chuck Jaffe at MarketWatch.com), the five-year return for the S&P will swell to an annualized 14.5 percent. The table here shows returns and projected returns for the 20 largest actively managed stock funds.)
Of course, if the market tanks between now and year's end, the five-year numbers won't look quite so pretty. But it's extremely unlikely that stocks will lose anywhere near as much as they did in the last four months of 2008, when the S&P index surrendered 28.9 percent. And, assuming that the market doesn't collapse in early 2014, the five-year returns will continue to swell a while longer because the S&P 500 plunged 25 percent from the start of 2009 until the market bottomed on March 9 of that year.
The picture is even more dramatic for foreign-stock funds. Assuming that the MSCI EAFE, which tracks mostly large-company stocks in developed nations, is flat between Sept.1 and the end of 2013, foreign stock funds will look even hotter. The EAFE index returned only 2.1 percent annualized for the five years that ended Aug. 31. But if the index merely stays flat, the five-year annualized return will balloon to 9.6 percent.
Returns for emerging-markets funds will also inflate. At the end of August, the MSCI Emerging Markets index had returned an annualized 2.2 percent over the previous five years. If the index is unchanged for the rest of the year, the five-year annualized return will balloon to 12.9 percent.
I'm willing to bet that we're about to get bombarded with ads from mutual fund companies crowing about their funds' five-year returns.
But savvy investors shouldn't forget what happened to funds during the cataclysmic 2007-09 bear market. In my view, you learn more about a fund from a bear market than you do from a bull market. It's nice to own funds that beat the indexes in bull markets. But it's much more important to own funds that hold up better than the benchmarks in down markets. And the sad fact is that precious few funds can beat the averages in both bull and bear markets. For the most part, you have to pick your poison.
With that in mind, look at the funds in the aforementioned table. It's easy to separate the riskier funds from the safer ones. Dodge & Cox International Stock (DODFX), which lost 62.3 percent, and Dodge & Cox Stock (DODGX), down 62.1 percent, top the bear-market losers. That's a large part of the reason they're on my avoid list. (In this matter, my views diverge from those of the editors of Kiplinger's Personal Finance; both funds are members of the Kiplinger 25.)
I think you should be more forgiving of two other big losers among the foreign funds: Harbor International (HAINX), down 57.9 percent, and Oppenheimer Developing Markets A (ODMAX), off 56.3 percent, because they lost less than their benchmark indexes. Both are quality funds (although you may have to pay a commission to buy the Oppenheimer fund).
On the positive side, Vanguard Health Care (VGHCX) lost just 35.5 percent, which not only shows the defensive characteristics of this sector but also speaks well for the fund.
But the two diversified funds that held up best in the bear market, Fidelity Contrafund (FCNTX) and Vanguard Primecap (VPMCX), both off 47.8 percent, are the real winners here. I don't know how Fidelity's Will Danoff continues to put up great numbers with $97 billion in assets, but he does. Similarly, Primecap Management Company, which runs the Vanguard fund, is managing a boatload of money in the same style in several different funds, but it does so superbly.
The bottom line: Stock funds got a true stress test during the bear market. Their sponsors want you to forget those big losses. But in picking funds, this is a number to always keep in mind. Five-year returns are informative, too. But they change, sometimes dramatically, for reasons that have nothing to do with what their managers have done lately.
