“Past performance is not necessarily indicative of future results.” Just eight words that have been repeated enough in mutual fund marketing materials for investors to tune out their message; or perhaps they have chosen to ignore the most important of those eight words, the word NOT.

Why is selecting a mutual fund solely on whether it has a good track record an inappropriate way to make investment decisions? There are numerous reasons, but let’s boil it down to answering three key questions:

Whose Track Record Is It?

Mutual funds love to boast about outperforming their peers or a benchmark over certain periods of time, slicing the data to focus on the short or the long-term, depending on which one was more impressive. But it is important to remember that the track record of a fund is inextricably linked to whomever has been making the final portfolio allocation decisions, and investors should do their due diligence on how much of the current management team’s track record lines up with the performance figures touted in a fund’s marketing materials.

When a manager or key members of his or her team leave the fund, voluntarily or not, at least part of the fund’s record and knowledge base also departs. Management changes at mutual funds occur periodically — 11% of domestic equity funds ranked by S&P Equity Research have seen new management take over since January 2010 — and often are announced through supplemental prospectus that can easily be overlooked. So investors should make sure that during whatever time period they choose to focus on when selecting a fund that the current management has been at the helm for at least that long.  A new manager, even someone who has worked at the fund family for years, can incorporate a new investment style or might make notable changes to the portfolio that can add entirely new risk considerations to a mutual fund.

How Was the Track Record Achieved?

Most investors look at a fund’s three-year record to determine if that fund fits with their investment goals. Looking back at the last three years, it was anything but a quiet period, with the credit- and financial-crisis-inspired bear market of 2008 making way for what is now a bull market that just entered its third year. When we look at S&P MarketScope Advisor’s list of some of the better performing U.S. equity funds ranked by S&P Equity Research — which includes funds up more than 10% on a three-year annualized basis — many of these same funds lost 40% or more in calendar year 2008, before bouncing back by investing in stocks that benefitted from the economic recovery. These recent top gainers achieved success with standard deviations significantly higher than the S&P 500 Index and of its peer group. S&P believes a relatively high standard deviation is a key indicator of a fund incurring greater risk to generate returns, negatively impacting the investment. While such risk taking might be appropriate for some investors, if you own a fund like the above, be sure you have the stomach for it because most managers who swing for the fences will also strike out a lot.

What Drove the Fund’s Performance?

On a sector basis, the place to have invested in 2010 was consumer discretionary stocks, with the relevant S&P index up 27%, far outpacing the broader S&P 500 Index’s gain of 13%.

Numerous consumer stocks, including large-caps Disney (DIS) Home Depot (HD) and mid-caps Foot Locker (FL) and Panera Bread (PNRA) rose sharply in 2010 as consumer spending returned. While just one full quarter is in the books for 2011, the energy sector, helped by a spike in oil prices, has been the darling of the market, with the relevant S&P index rising 17% and trouncing the 500’s more modest 5.4% rise as of the end of March 2011. 

When looking to invest in a fund, be sure to note if the recent gains resulted from making large sector bets. Not surprisingly, many of the best performing mutual funds in the first quarter of 2011 were energy-focused funds, but if oil prices move lower their success will be hard to duplicate. In addition, not all stocks within a sector are attractive. Of the four consumer stocks listed above, just two of them (Disney and Foot Locker) are currently being recommended for purchase by S&P Equity Research, which covers approximately 1,300 domestic stocks, while Home Depot and Panera Bread currently have “Sell” recommendations from S&P. Knowing the sector breakdown and characteristics of the stocks recently held in a mutual fund can help investors determine if they are holding just the “recent winners” or if, in fact, they have found a fund that is well positioned for the future. 

Whether investors are searching for a new mutual fund to add to their portfolio or just reviewing their current allocations, they need to avoid relying solely on past performance. Augmenting performance-based research by looking at manager tenure, volatility and the fund’s underlying holdings can put past performance numbers in perspective. At S&P Equity Research, we believe there are multiple factors that determine if a mutual fund has strong fundamentals, because what worked in the past might NOT work again.

Todd Rosenbluth, a senior director at S&P Equity Research, leads the firm’s mutual fund research efforts and oversaw the design and development of S&P’s mutual fund research and ranking methodology. His updates on the mutual fund industry and specific funds can be found at S&P’s MarketScope Advisor website.