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Investors Too Often Focus On a Fund's Past Performance

By Ali Jaffery

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You can't buy a mutual fund's past performance. But lots of folks try.

Investors are forever flocking to last year's best-performing funds, while fleeing those that have sunk in value. At the best of times, this is a dubious strategy. But right now, it could be downright dangerous.

Consider the outlook for stock, bond and money-market funds:

Trashing Cash

As 2002 draws to a close, money-market funds are yielding just 1%, down from an average 5.7% in 2000. Upset by such lowly yields? Blame it on Federal Reserve Chairman Alan Greenspan.

As the Fed has endeavored to re-ignite economic growth, it has slashed short-term interest rates. Those lower rates make it cheaper for corporations to borrow. But it also hurts savers, who have seen yields plunge.

Eventually, the Federal Reserve will decide the economic recovery is on track and it will start nudging up interest rates. But savers aren't likely to get relief any time soon.

What to do? Swapping out of your money-market fund is probably a smart move. But think carefully about where you move the money, because this is a treacherous time to be reaching for yield.

Eyeing Income

When the economy comes out of recession, both short-term and long-term interest rates tend to rise, as inflation picks up, demand for borrowed money grows and the Federal Reserve pushes up short-term interest rates. Because bond prices move in the opposite direction from interest rates, those rising rates can lead to hefty losses for bond investors.

But will rates rise? When yields on 10-year Treasury notes fell to 4.5%, I was convinced rates couldn't decline much further. But instead, rates dropped below 4%, before bouncing back recently.

Thanks to the drop in rates, long-term government-bond funds clocked 9.3% in this year's first 11 months, according to Chicago fund researchers Morningstar. But while investors have favored the super safety of government bonds, they have been less enthused about corporate bonds, especially those issued by shakier companies. Indeed, high-yield junk-bond funds are down 2.8% in this year's first 11 months.

If we suffer deflation, with the economy stagnant and consumer prices actually falling, this performance gap could persist. But that seems unlikely. Instead, I believe investors are better off assuming that the economy will continue to recover. If that happens, government bonds will probably tumble as investors regain their confidence and opt for the higher yields offered by corporate bonds.

My advice: If you are cowering in government bonds or you are looking for an alternative to money-market funds, consider a low-cost short-term bond fund, preferably one that owns at least some corporate bonds.

What if you don't want the share-price fluctuations that come with a bond fund? For those willing to lose some financial flexibility, consider savings bonds, and stable-value funds, all of which offer a chance to earn moderate yields, without risking principal.


Stocking Up

Even as folks load up on government-bond funds, they have been dumping stock funds. Among stock investors, the mantra of the late 1990s was "buy on the dips." Today, it seems to be "sell on the rallies."

After the battering of the past three years, people have clearly lost confidence in stocks as a long-term investment. But this is foolish. Stocks are a much better value now than they were at the March 2000 stock-market peak. One popular valuation model suggests stocks are some 30% undervalued relative to bonds.

The market decline has also brought a renewed bashing of stock-index funds. Supposedly, we are in a "stock picker's market," where actively managed funds are a better bet than index funds, which simply seek to replicate the performance of a market average.

Active managers have indeed fared better through the bear market, according to a recent study by Standard & Poor's, a unit of McGraw-Hill.

The study found that 54% of large-company stock funds have outpaced the S&P 500-stock index over the past three years.

But I wouldn't bank on actively managed funds continuing to flourish.

The fact is, much of the recent performance edge can be explained not by active managers' stock-picking prowess, but by their cash holdings. That cash has helped cushion the blow from falling stock prices. By contrast, index funds remain fully invested in stocks, so they don't have this cash cushion.

What if stocks continue their recent rally? Active managers will find it tougher to keep up with the indexes.

In fact, over the past five years, which includes both the bear market and part of the preceding bull market, just 37% of U.S. large-company stock funds managed to beat the S&P 500.

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