Investment Products


Gold Didn’t Pan Out

gold tumbles

April 2013: Gold dropped to its lowest level in two years – on top of a 10% fall over the past six months.

Gold was supposed to be a secure investment in an uncertain time – so much so that an April 2011 Gallup poll found that 34% of Americans thought that gold was the best long-term investment, more than another other investment category.

Then,  two years after its price reached a new high, it plunged to its lowest level in over two years, falling 19% since late 2011. This is the greatest decline in 33 years, amid record-high trading.

According to the New York Times, the crash of a golden decade of rising prices caught many investors by surprise. Morningstar reports that $5 billion  had flowed into gold-focused mutual funds between 2009 and 2010, bringing those funds to a peak value of $26.3 billion in April 2011. These funds lost half of their value:

It is a remarkable turnabout for an investment that many have long regarded as one of the safest of all. The decline has been so swift that some Wall Street analysts are declaring the end of a golden age of gold. The stakes are high: the last time the metal went through a patch like this, in the 1980s, its price took 30 years to recover.

In a time of plunging global interest rates, why did investors flock to a traditional  inflation hedge?  Why were they willing to buy at such high prices? It seems that many investors mistook gold for a product that could provide them significant protection against economic risk – more in line with an insurance product.

What’s A Safe Investment?

It’s certainly understandable that people would seek a safe haven at a time when many are losing faith in their political and economic systems. However,  given that there are few safe investments to turn to considering the low returns that interest-bearing products have been offering, the allure of gold was perhaps understandable:

inflation-interest-rates-1945-2011

Investopedia’s “4 Safest Investments Right Now” – which includes TIPS, I-Bonds, Short Term Bond Funds, and Bank CDs –  have such modest returns that they essentially just aim to preserve principal. Investopedia states:

Any one of these options represents a low-risk low-return solution to preserving principal. You won’t earn much in returns with these securities though. In most cases it will be just enough to keep level with inflation. If you need capital appreciation over the long term, you’ll have to take on more risk.

A Different Approach to Wealth Preservation

One financial vehicle that has recently been enjoying a resurgence of interest is permanent life insurance.  life-insurance-age-range

2012 was a very big year for permanent life insurance sales according to research and consulting firm LIMRA, :

  • Total individual life insurance new annualized premium grew 6% — the third straight year of growth.
  • Total individual life premium grew 12% in the fourth quarter — the largest growth recorded since the downturn.
  • Life insurance policies sold grew 1%  — the second consecutive year of positive annual policy growth.

The fourth quarter of 2012 was the biggest quarter for life insurance sales in a very long time – in fact, there hasn’t been a quarter in which all of the major product lines experienced growth since 2006. And the last time individual life insurance policy count increased two years in a row was back in 1980-1981.

Creating Certainty In An Uncertain World

Why the sudden resurgence of interest in life insurance? LIMRA’s Product Research senior analyst Ashley Durham attributes growth to a few different factors, including a continued attraction to guarantees and growth potential. What differentiates permanent life insurance from other financial vehicles are 3 unique benefit features:

1. Competitive Return Potential

high returnIn today’s volatile markets, secure financial vehicles that provide competitive returns are hard to find.  In an environment of such low returns, permanent life insurance’s cash value provides an interesting alternative.    and  put it this way in Advisor One:

Considering the premium placed on stability in recent years, investing in a permanent life policy might be the best bargain on the market.

2. Lifetime Guarantee

In addition to providing a cash value savings element, permanent life insurance provides a feature that other financial vehicles doLifetime-Guarantee not: lifetime guarantees.

Given increased life expectancy and declining health over time, there is no guarantee that the money you put aside for your beneficiaries will ever reach them. You are likely to need it first for medical or other expenses. However, if you own permanent life insurance, you can access policy cash values without surrendering the death benefit. There is also little chance of outliving a permanent life insurance policy, because permanent life policies can remain in force to age 100, and with some policies, to age 120. And, although you may be living on a fixed income as a retiree, life insurance premiums remain fixed for life, or can be paid up in advance.

3. Potential for Explosive Growth

A Wealth Multiplier: The transfer of risk is essential to life insurance. The risk of  a payout to you at death isn’t retained by you alone, but  spread out among all policyholders that the insurer does business with. All customers contribute money to the general account, which is invested, and then claims are paid from it when an individual dies. As a result, the  annual or monthly premium you pay is a small fraction of the benefit that will be paid to your beneficiaries at death.

Chart_SideBySide

Example: The chart shows a 65-year-old man who purchases of a policy with a $1,000,000 death benefit for a $26,000 annual premium. In the year of his life expectancy the adjusted Internal Rate of Return (IRR) of his death benefit is 5.88%, or, since he is not taxed, 8.17%.
If he passes away earlier, his IRR will be higher – as high as 108.28% at age 79.  
  • In other words, you don’t have to be a big saver to leave a substantial legacy to your beneficiaries. The death benefit paid to your beneficiaries can be many times what you paid into it.
Tax Efficient Transfer: The policy proceeds bypass the often lengthy and costly probate process, and are released to your beneficiaries immediately – which is when they are likely to need it the most – without taxation.

Short on Glitter – Long on Performance

pig

This resurgence of interest in life insurance is a reminder of the uncertainty of our times, and an indicator of changing consumer attitudes. Consumers are more knowledgeable, and LIMRA research indicates that more knowledgeable people are on the subject, the more likely they are to own life insurance. LIMRA found that:

Respondents who knew the most about life insurance. citing multiple sources of information attributing to their understanding of life insurance, either owned life insurance themselves or had heard about it through work, a seminar or financial planner. Most were older, more educated and viewed life insurance as important.

It seems that the smart money is leapfrogging gold.  Life insurance may lack the psychological appeal and rich associations of gold – no pirate ship ever went down with universal life insurance contracts in their hold – but what it lacks in luster, it makes up for in substance and performance:

  • Many gold investors bought high and sold low. However, life insurance is actuarially designed to be bought low and sold high – the premiums represent just a fraction of the proceeds.
  • While the price and value of gold fluctuate subject to general economic conditions and investor sentiment, permanent life insurance usually offers a guaranteed level premium and a guaranteed death benefit.
  • For your beneficiaries, life insurance represents “inevitable gain” tax free.

A dull, plodding performer, life insurance nonetheless provides dependable benefits – it provides down payments to help young families buy their first homes, college educations to launch bright careers, hard cash to pay bills when the earner is not there to provide.

Gold certainly may have a place in your portfolio. Financial planners typically recommend that you allocate a small portion of your portfolio to it to serve as a hedge against financial risk. However, consider how much more protection investors would have by placing a portion of that into permanent life insurance.


The above chart is from  the ETF Database, a great resource for everything on ETFs.

Exchange Traded Funds In A Nutshell

Exchange-traded funds (ETFs) and mutual funds are both viable choices for investors. But, with all their similarities, what differences between the two should investors consider when deciding which to use?

General Overview

Launched in 1993, ETFs are designed to offer the diversification of a mutual fund and the liquidity and transparency of a stock. Whereas mutual funds can typically be traded only once a day, based on their end-of-day value, ETFs can be bought and sold in real time throughout the trading day. The ETF is similar to a mutual fund in that it is a diversified basket of investments. Like mutual funds, ETFs have a particular investment focus –  for instance, ETFs may be made up of only technology stocks, or energy stocks. They may follow indexes: there are some that follow the movement of the Chinese economy and others that track a basket of commodities like corn and wheat. But there are differences:

  • While a mutual fund can only be bought at the end of the day value, ETFs are traded on an exchange throughout the day just like a stock.
  • ETFs have managers but are not managed as actively as some mutual funds. Most of the underlying stocks stay the same over time which helps keep the fees much lower than most mutual funds.

Legal Structure

Mutual funds can typically be broken down into two types:

  • Open-Ended Funds
    Purchases and sales of fund shares take place directly between investors and the fund company. Federal regulations require a daily valuation process, called marking to market, which subsequently adjusts the fund’s per-share price to reflect changes in portfolio (asset) value. The value of the individual’s shares is not affected by the number of shares outstanding.
  • Closed-End Funds
    These funds issue only a specific number of shares and do not issue new shares as investor demand grows. Prices are not determined by the net asset value (NAV) of the fund, but are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.
[ETF_chart]ETFs
An ETF will have one of three structures:

  • Exchange-Traded Open-End Index Mutual Fund
    Under the SEC’s Investment Company Act of 1940, dividends are reinvested on the day of receipt and paid to shareholders in cash every quarter. Securities lending is allowed and derivatives may be used in the fund.
  • Exchange-Traded Unit Investment Trust (UIT)
    Exchange-traded UITs must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less, and set additional weighting limits for diversified and non-diversified funds. UITs do not automatically reinvest dividends, but pay cash dividends quarterly.
  • Exchange-Traded Grantor Trust
    This bears a strong resemblance to a closed-ended fund but, unlike ETFs and closed-end mutual funds, an investor owns the underlying shares in the companies that the ETF is invested in, including the voting rights. The composition of the fund does not change; dividends are not reinvested but instead are paid directly to shareholders. Investors must trade in 100-share lots. Holding company depository receipts (HOLDRs) are one example of this type of ETF.

Active Trading
ETFs offer greater flexibility than mutual funds when it comes to trading. For mutual funds, the price of the fund is not determined until end of business day, when net asset value (NAV) is determined. With ETFs, however, shares trade throughout the day between investors like a stock. Because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage. (See Arbitrage Squeezes Profit From Market Inefficiency.)

Lower Expenses
Due to the passive nature of indexed strategies, the internal expenses of most ETFs are considerably lower than those of many mutual funds. Of the more than 900 available ETFs listed on Morningstar in 2010, those with the lowest expense ratios charged about .10%, while those with the highest expenses ran about 1.25%. By comparison, the lowest fund fees range from .01% to more than 10% per year for other funds.Another expense that should be considered is the product acquisition costs, if any. Mutual funds can often be purchased at NAV, or stripped of any loads, but many have commissions and loads associated with them, some of which run as high as 8.5%. ETF purchases are free of broker loads. (See The Lowdown On No-Load Mutual Funds.)

In both cases, additional transaction fees are usually assessed, depending on the size of your account, the size of the purchase and the pricing schedule of the brokerage firm. If you plan to use dollar-cost averaging to buy into the funds or ETFs,  frequent trading could significantly increase commissions, offsetting the benefits resulting from lower fees.

Tax Advantages
ETFs offer tax advantages to investors:

  • As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.
  • ETFs are more tax efficient than mutual funds because of the way they are created and redeemed. For example, if an investor redeems $50,000 from a mutual fund, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, the fund captures that capital gain, which is distributed to shareholders before year-end. Shareholders must pay taxes for the turnover within the fund.  But if an ETF shareholder wishes to redeem $50,000, the ETF doesn’t sell any stock in the portfolio, but offers shareholders “in-kind redemptions”, which limit the possibility of paying capital gains.
Potential for Less Liquidity
Broad-based index ETFs with significant assets and trading volume have liquidity. For narrow ETF categories, or even country-specific products that have relatively small amounts of assets and are thinly traded, ETF liquidity could dry up in severe market conditions, so you may wish to steer clear of ETFs that track thinly traded markets or have very few underlying securities or small market caps in the respective index.ETF Safety Concerns
Investors should not invest in ETFs of a company that is likely to disappear,  forcing an unplanned liquidation of the funds that could create a taxable event. Since it is impossible to gauge the financial viability of a startup ETF company, as many are privately held, you should limit your ETF investments to firmly established providers or market dominators.

The “Flash Crash”

The “flash crash” showed that ETFs can be far more complex—and risky—than their mutual-fund cousins. Worse, ETF investors were burned at the very moment they craved safety most. On May 6, when the Dow Jones Industrial Average fell as much as 9.2% during the trading session, many ETFs momentarily lost almost all their value, dropping to pennies per share. Exchanges decided to cancel any trades executed at prices 60% or more away from precrash levels, and ETFs, which account for just one-tenth of all exchange-traded securities, represented about 70% of those with canceled trades. Instead of behaving like broadly diversified baskets of stocks, ETFs performed like single stocks reacting to the actions of panicked traders. The market prices of the ETFs plunged 60% or more.

Making matters worse, many ETF investors had placed “stop-loss orders”  designed to protect investors by triggering a sale once the ETF hits a certain level. When ETF prices plunged, however, there were few buyers, and many sold far below the trigger price selected. Then the funds rebounded sharply, adding insult to the injury.

Mike Goldberg, 64 years old, of Sarasota, Fla., had purchased the PowerShares Dynamic Leisure & Entertainment ETF at about $15 a share and set a stop-loss order to be triggered at roughly $14. But when he checked his account after the flash crash, he discovered that he had sold some of the shares at just 13 cents. “I remember reading it and saying, ‘Was there a typo?,'” says Mr. Goldberg, who owns a travel-marketing company. “I was a little bit annoyed.” Ultimately, the trade was canceled.

That isn’t to say the flash crash destroyed the rationale for using ETFs. The funds often charge lower fees than traditional mutual funds, and offer easy access to broad slices of the market. And ETFs may allow investors who can’t afford a mutual fund’s minimum initial investment—often $3,000 or more—to buy a similar holding for the cost of a trading commission. Major firms like Vanguard Group and Fidelity Investments have even started offering commission-free trades on some ETFs.

With ETFs, “you can get lower fees and tax efficiency, so long as you tread carefully and trade wisely,” says Paul Justice, ETF strategist at Morningstar.

For those investors still willing to consider exchange-traded funds, here are some new rules to trade by.

Rule 1: Check your wonk tolerance.

The mechanics of ETFs are more complicated than most investors and financial advisers ever realized. If you aren’t willing or able to keep up with the swings in the market or the technical discussion that follows here, it is a good sign that you should stick to ordinary mutual funds.

Rule 2: Try not to trade on a volatile day.

Big institutional players can help ETFs trade smoothly and closely track their benchmarks. But when the markets dive, they won’t necessarily prevent ETFs from plummeting.

So-called market makers—firms that typically help maintain orderly trading in ETFs—need accurate values for underlying fund holdings to arrive at prices where they are willing to buy or sell ETF shares. As stocks swung wildly on May 6, it became tough for these and other institutional players to price ETFs confidently, so many stepped back from the market, potentially exacerbating the rout.

On the all-electronic NYSE Arca, the primary exchange for most ETFs, the lead market makers have certain obligations to keep ETFs trading smoothly, though the exchange doesn’t disclose all of its requirements. These firms made a “reasonable effort” to keep up with the fast-moving market during the flash crash, says Lisa Dallmer, a chief operating officer at NYSE Euronext who oversees exchange-traded products. But given the steep market decline, she says, “it clearly wasn’t enough, because we had trades going off at a penny.”

Many ETF trades on May 6 were executed at “stub quote” prices. These quotes are market makers’ placeholders, often bids to buy shares for just pennies, and never meant to be executed. The phenomenon bewildered even some industry veterans.

“I never heard of stub quotes before in my life,” says Jim Ross, senior managing director at ETF provider State Street Corp. STT +2.44%

[ETF_TABLE]

Other institutional players, such as high-frequency firms that trade ETFs at blinding speed, also provide liquidity in normal markets. But in a meltdown like May 6, “you can’t mandate that a high-frequency trader stand up on the firing line,” says Gus Sauter, chief investment officer at Vanguard Group.

In the wake of the flash crash, exchanges and regulators proposed “circuit breakers” for individual stocks in the Standard & Poor’s 500-stock index, to help prevent another flash crash. The NYSE’s Ms. Dallmer says the exchange has proposed a list of ETFs that could be a part of this circuit-breaker pilot program, pending the Securities and Exchange Commission’s approval.

Even so, small investors are better off not trading ETFs on the market’s wildest days. And for investors who aren’t comfortable with all of these arcane exchange policies, there is a simpler solution: Stick with ordinary mutual funds.

Rule 3: Use the right kind of trade order.

Even the procedure for buying or selling an ETF can trip up investors.

A “market order” means the trade will be executed at whatever price the market gives you. But as the flash crash showed, those market prices can get unpredictable—quickly.

Investors trading ETFs should use “limit” orders, says Morningstar’s Mr. Justice. That means the trade will be executed only within a specified price range. “You’re not guaranteed execution, but at least [you’re] guaranteed a price,” Mr. Justice says.

Among the strangest results of the flash crash are stop-loss orders turned upside-down.

Dave Hamra, a financial planner who runs Gordian Advisors in Tucson, Ariz., had bought shares in the Vanguard Total Stock Market VTI +2.06% ETF for two clients at about $54 apiece. He placed a stop loss at $50. On the afternoon of May 6, as the ETF’s price bungee-jumped around, Mr. Hamra’s clients got stopped out at an average price of $57.40, or 15% above the stop-loss he had set.

“It was really, really weird,” Mr. Hamra says. Though he has found no explanation for what happened, “I’m much less inclined now to use any stop losses at all,” he says.

Rule 4: Pay attention to trading costs.

Investors tend to think of ETF trading costs only in terms of the commission paid to buy or sell. But the “bid-ask spread,” which is the gap between the price buyers are willing to pay for ETF shares and the price sellers are asking, also can take a sizable bite out of returns.

Though ETFs appear highly liquid, trading billions of shares per day, that liquidity is largely concentrated in a handful of funds. At the end of April, the 10 ETFs with the largest dollar trading volume accounted for more than 60% of total ETF volume, according to the National Stock Exchange.

During the flash crash, typically narrow bid-ask spreads on some ETFs widened considerably. The iShares Russell 3000 Value Index, for example, had an average bid-ask spread of four cents in the first four months of this year; on May 6, its average spread was $2.29, according to NYSE Arca. Investors should generally be wary of ETFs with bid-ask spreads of more than five to 10 cents, analysts say.

Rule 5: Check the underlying value of the fund holdings before trading.

ETF market prices typically hew closely to the value of the fund’s underlying holdings. That is partly because big investors known as “authorized participants” can swap ETF shares for baskets of the underlying securities, arbitraging away any valuation gaps between the two.

But during the flash crash, some ETF prices momentarily bore little resemblance to their underlying holdings. The Vanguard Total Stock Market ETF, for example, seemed to track the market through its sharp decline and the start of its recovery, then collapsed again as its price briefly hit 15 cents, according to a regulatory report.

ETFs also can trade at prices substantially above their net asset value.

To determine if an ETF’s market price is reasonable, investors should check its “indicative” net asset value before they trade. The INAV, calculated every 15 seconds, is an up-to-date snapshot of the value of the fund’s holdings.

The flash crash showed that ETFs require lots of legwork, prompting some investors to wonder if the securities are worth the hassle. Mike Personick, a 33-year-old Salt Lake City small-business owner, is trying to switch from ETF market orders to limit orders in light of the crash. But if it is too much trouble, “I’ll go back to mutual funds,” he says. “I don’t have time to sit around and watch the market all day.”

Investopedia has a tutorial that you may find useful:

The Wall Street Journal’s Dartboard Contest

Meet Your New Money Manager

Economist Burton Malkiel, author of A Random Walk Down Wall Street held that because financial markets are “informationally efficient,” an investor can’t consistently achieve returns in excess of average market returns on a risk-adjusted basis. He drove the point home with the contention that that even a blindfolded monkey throwing darts could do as good a job in picking stocks as a professional money manager.

Game On

The Wall Street Journal created it’s famous Dartboard Contest in 1988 to test the theory. The Journal made random stock picks and compared these to picks by investment experts as well as those of readers, and, in 1998 published the results of the 100th dartboard contest.

Results: Not Very Impressive

The results appear to show that nobody’s really able to consistently outperform the market:

  • The experts beat the monkeys only 61% of the time.
  • The experts essentially tied the Dow Jones Average (51% record.)
  • The experts’ average return was just 10.8% compared to 6.8% for the Dow and 4.5% for the random picks.

Is Index Investing The Answer?

The contest appears to show that – even without factoring in taxes, management fees, and the low likelihood of outperforming the benchmark indexes,  an investor should be able to outperform professional money managers about half the time only by investing the Dow Jones Industrial Average.

The major advantages of index investments, according to Money Crashers:

  1. Markets Are Efficient. The indexer basically believes that the market as a whole is very good at quickly pricing all the available information about a stock or a market into the market price (i.e. efficient market hypothesis). It is therefore almost impossible for a given money manager to outguess the market consistently over a long period of time.
  2. It Is Very Difficult to Identify Winning Fund Managers in Advance. Looking at the returns of the top fund managers every year, in the majority of cases, a fund manager will outperform for a year or two, but when another investment style becomes popular, they decline. The indexer doesn’t believe it makes sense to try to guess who will be this year’s best performing manager.
  3. Mutual Fund Managers Cannot Reliably Add Value Beyond Their Costs. In the aggregate, mutual fund managers and other institutional investors cannot reliably beat the market. The reason: collectively, they are the market, and should under-perform a well-constructed index by approximately the amount of their costs.
  4. Index Funds Have Lower Turnover. It costs money to churn – or excessively trade – securities in your portfolio. Mutual funds have to pay brokers and traders, and must also absorb the hidden costs of bid-ask spreads every time they trade. The bid-ask spread is the difference between what a stock exchange market maker pays for the stock and what they sell it for. Brokerage firms identify the overlap between what investors are willing to pay for a security and what investors are willing to sell a security for, and make part of their money by pocketing the difference. The more trading a fund does, the higher these costs. But index funds never have to trade, except when new securities are added to the index, or to buy or sell just enough to cover fund flows coming in and out as investors buy or sell.
  5. Index Funds Are Tax-Efficient. Every time a mutual fund sells a holding at a profit, it must pass that profit on to its shareholders, who pay capital gains taxes on that profit (except for funds held in retirement accounts, like an IRA or a 401k.) Index funds are normally tax-efficient, due to low turnover. This isn’t relevant fbut it’s a major consideration for mutual funds held outside of retirement accounts. For this reason, index funds are popular choices for use in taxable (non-retirement) accounts.

 A Counter Argument

Warren Buffett, who is among the most successful value  investors, rejects the logic of efficient markets. He made fortunes by buying stocks at a discount to their intrinsic value. Because the efficient market theory doesn’t hold in every case, he looks for stocks that markets are pricing too low, and has been successful finding stocks selling for 30%, 40%, or even 60% off of their true worth.

The downside is that it takes a great deal of time and frequently leads to very narrow portfolios, which can mean more volatility. Investors have to decide whether they want to pay a manager a percentage to pick securities for them, or just keep the fee and invest it, rather than paying it to the manager.

How would Warren Buffet answer that objection? Well, for most people who don’t have the time and expertise to dig deeply into analysis and research, Buffet himself recommends the indexing approach.

More reading:

Monkey business – Forbes.com

Journal’s Dartboard Retires After 14 Years of Stock Picks – Wall Street Journal (Google Cache)

Investing in Index Funds vs. Managed Mutual Funds

Buffett: Index funds better for most investors – Reuters

Marketing Returns

Jim Lowell, Fidelity Investor, in a Forbes article, brings our attention to two possibly misleading practices in reporting performance numbers that can be used in Mutual Fund advertising campaigns:

  1. How fund returns are calculated.
  2. Who earned those returns.

1. Annualized Returns Don’t Tell the Whole Story

“Annualized” returns don’t tell the whole story on fund performance. In fact, they can mask the real story.

Flat Yet Soaring?Jim gives the example of 2005, a volatile year, and by the third quarter, returns were flat. Yet, looking at the chart below, several funds report being up. How can that be?

In times of high volatility, the performance numbers you see over a period of a few months can be very confusing when taken out of context. This can make the quarter-end rankings of mutual funds by their three-year, and sometimes five-year, numbers unreliable. Citing returns through the end of 2005’s third quarter focus on single-period returns, and lack context. Returns for the single 3-year period and single 5-year period ending in September 2005, can be very misleading.

The Greater Context – Compared to What?: The bear market virtually hit bottom at the end of September 2002, hitting a nadir in mid-October before rebounding for a positive return that month. Consequently, by the end of the third quarter, 2005, the 3-year returns ending September 2005 would be up compared to that dismal period, and that would make them look a bit too rosy.

By contrast, the 5-year numbers might look a little worse than they should, given that their starting point, the end of September 2000, saw the stock market just 6% below its March record high.

The table below shows (in red) spectacular looking annualized 3 year returns, while the five-year numbers mostly look dismal. The net result is that, ranking the funds by their 3-year returns, the ranking would look quite a bit different from the ranking based on 5-year returns.

However, look at the average 3-year and 5-year rolling returns for each of the funds in the list based on monthly performance going back 10 years (in blue.) Ranking the funds by these rolling return figures, youfind much greater consistency in relative fund performance.

One important reason is that the 3- and 5-year returns measure just two time periods, but the rolling returns measure more than 80 three-year and more than 50 five-year periods.

Annualized Returns Are Inconsistent, Rolling Returns More Consistent

Fidelity Fund 3-Year  Annualized % Return 5-year Annualized % Return 3-Year Rolling % Returns 5-Year Rolling % Returns
Aggressive Growth 17.1 -20.7 3.3 -2.4
Capital Appreciation 20.1 0.3 8.4 6.5
Contrafund 15.8 3 9.6 7.5
Value 20.4 14.4 9.2 9.1
Utilities 19 -4.6 4.8 1.5
Diversified International 21.2 6.3 9.8 8.5
Emerging Markets 27.5 8.5 -3.2 -3.8
Medical Delivery 23 21.3 6.6 8.4
Excerpted from the September 2005 issue of Jim Lowell’s Fidelity Investor . Click here for more of Lowell’s insights and analysis of Fidelity funds, and to subscribe to Fidelity Investor.

2. Manager Changes Aren’t Accounted For

Over the five years ending in 2005, there were more than 50 manager changes at Fidelity, and this is consistent with the average manager turnover rate in the fund industry.

Yet, rating agencies like Morningstar employ systems based on past fund performance rather than the individual manager’s performance history. So, even though the manager who may have been responsible for the actual performance of the product may no longer be running the fund, the funds may continue to use those ratings to promote their fund products.

Jim Lowell questions whether there might be an increase in manager turnover as many younger guns or experienced hands take the opportunity of their glowing short-term numbers to advance their careers by moving to a new fund family, or jumping from mutual funds to hedge funds, or from retail funds to institutional ones.

Bottom Line: Put 3- and 5-year “rankings” in perspective and read the fine print.