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Short-term views on mutual funds deceptive

– Fabulous can have a flip side.

It’s something investors should remember as mutual funds’ five-year return figures grow more eye-popping by the day. Many funds have more than doubled over that time, but that’s due in part to the calendar creeping closer to the five-year anniversary of the March 9, 2009, bottom for the market. That means the darkest days of the financial crisis are no longer counted in five-year returns, leaving only the recovery that sent the Standard & Poor’s 500 index to a record high.

The anniversary is a key milestone because many potential investors scrutinize a fund’s five-year record when deciding whether to buy a fund. It’s important, though, to put those stellar performance numbers in context and to temper expectations.

Market conditions are stacked against both stock and bond mutual funds having such strong returns the next five years, analysts say. Plus, some of the funds with the best five-year returns led the pack because they focused on the riskiest investments. Many conservative managers, meanwhile, got left behind in the bull market.

To see how big the numbers are, check the performance of the largest mutual fund by assets. Vanguard’s Total Stock Market Index fund (VTSMX) has a five-year annualized return of 23.2 percent, according to Morningstar. At the end of 2012, its five-year annualized return was 2.2 percent.

To be sure, investors already have some experience with this effect. Something similar happened with funds’ three-year returns in early 2012.

A fund’s three- and five-year returns are typically the numbers that average investors find most important, says David Mertens, a principal at Jensen Investment Management. Its mutual funds include Jensen Quality Growth (JENSX), which has Morningstar’s gold medal analyst rating.

Mertens would prefer that investors give greater weight to a fund’s returns over 10 years or even longer. But “people tend to buy what’s just happened,” he says. “People buy yesterday’s story.”

Stocks are unlikely to rise as dramatically, in part because they don’t look as cheap as they did in 2009. One popular way to measure whether a stock is expensive is to divide the price of a stock by its earnings per share over the last 12 months.

Robert Shiller, a professor at Yale University and one of the winners of the Nobel Prize in economics last year, takes it a step further. He thinks it’s misleading to look at just one year because earnings can surge or drop in an economic cycle. To smooth out distortions, he looks at the S&P 500’s level versus its average earnings per share over the prior 10 years, adjusting for inflation.

By that measure, the S&P 500 in March 2009 was at its cheapest level in 23 years. Now, it’s nearly twice that level and back above its average since World War II.

That suggests future gains for stocks won’t come from a further rise in price-earnings ratios as much as from growth in earnings.

This year, analysts forecast earnings per share for S&P 500 companies to rise 7.9 percent.

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