Commentary

If you're a regular reader of Morningstar.com, you may be tired of our constant reminders to view short-term returns with a skeptical eye. Unless they're used to judge specifically whether a fund performed as one would expect under extreme conditions--such as a conservative fund holding up better than bolder rivals when high-priced growth stocks plunge--returns of six months or a year typically reveal little about a fund's worth or a manager's talent.

That's why we advise readers to consult longer-term records in order to obtain a deeper understanding of a fund.

Bad news. Because of the crazy up-and-down ride the stock market seems to enjoy providing us, now even 10-year returns must be examined with care. That will become more and more evident over the coming months. Keep this in mind when New Year's Day arrives and the decade's performance numbers are widely published and discussed.

That Was Some Party
In the fourth quarter of 1999, the long stock-market rally reached incredible heights. The S&P 500 Index rose 14.9%. The Nasdaq Composite climbed 48.2%. The frenzy continued into the first few months of 2000.

That story would be just ancient history--fodder for the cautionary tales rolled out by financial-planning authors--if it weren't for the approaching end of the 21st century's first decade. Unless the coming months provide a 1999-style blowout, many 10-year returns will change dramatically as we head into--and proceed through--2010. That's because a couple of spectacular quarters are about to be replaced by more mundane ones.

Take a look at BlackRock International Opportunities. For the 10-year period through the end of this year's third quarter (Sept. 30), the fund had an astounding 14.1% annualized return--the highest return of any international fund not specifically focused on emerging markets. But if you look at its return for this decade alone--that is, from Jan. 1, 2000, through Sept. 30, 2009--its annualized gain falls to 7.7%. That's still strong; it beats the relevant category averages. But that's a shocking difference simply for moving a starting point ahead three months. And that return doesn't land it as high in the rankings as the full 10-year number does right now.

The explanation is simple: In 1999's final quarter, BlackRock International Opportunities soared 81.6%. (The MSCI EAFE Index, which probably thought it was enjoying a darn good quarter, rose 16.8% in that time frame.) In fact, the fund then notched a further 39.5% gain in the first two months of 2000 (versus a 3.9% loss for EAFE). So, the fund's 10-year record likely will become even less impressive as next year progresses and the early months of 2000 disappear.

That's an extreme example. But there are many funds that outperformed mightily in the last legs of the stupendous tech/Internet rally and whose 10-year numbers and rankings consequently will soon be in flux.

It Works the Other Way, Too
The same effect will move the 10-year returns and rankings in the other direction for funds that lagged badly as the tech/Internet party reached its zenith. For example, through this year's third quarter, Ariel Fund had a 10-year return of 6.4%, landing in the 38th percentile of the mid-blend category. (It moved to that category from the small-value group in mid-decade in recognition of a changed portfolio.) That's not bad. But the fund's 10-year comparisons should look much more impressive in coming months.

Here's why: In 1999's fourth quarter, Ariel Fund posted a 0.9% loss (yes, in the same quarter that the BlackRock fund gained 81%). That lackluster showing trailed far behind the mid-blend category average--a 17.7% gain--and the small-value group's 5.9% return. The story grew worse in the first two months of 2000; Ariel Fund somehow managed to lose 15.6% while the average mid-blend fund gained 2.9%. (Besides its lack of tech names, some of Ariel's key holdings hit turbulence.) The typical small-value offering was roughly flat in that period.

Unless Ariel's performance collapses in late 2009 and early 2010--it's been having a great year so far--its 10-year figures should look relatively more flattering when those awful times from a decade ago roll off the calendar.

Why Not Wipe the Slate Clean?
To some thoughtful investors, it might seem prudent to expunge 1999's crazy ride from the records. For purposes of evaluation, aren't we better off throwing out a three-month gain of 81% achieved during an absurd time in the markets?

No. There's no reason to consider the new numbers and rankings that roll in over the next few months as more legitimate than the current ones. Although 1999's market conditions were highly unusual, so were those during the bear market that immediately followed and those in 2008's financial meltdown. The 2008 returns will live on in every fund's long-term record for years to come, and it's doubtful anyone (besides fund marketers) would want to change that.

Dealing with the Quirks
At times, therefore, a 10-year measuring stick can be as vulnerable to biases and quirks as a shorter period. That doesn't mean it should be abandoned. Anyone trying to make sense of fund performance must focus, at least initially, on certain time periods and use similar shortcuts with other data. Otherwise, the mass of information that grows more daunting every day would be impossible to process.

In the end, the key is to remember that all measurements, even those that seem most reliable, must be examined, evaluated, and placed in context. If you see a noteworthy change in a number from one month or year to the next or if you spot figures that don't seem to make sense, look beneath the surface. Such diligence will be worth your time over the coming months.

Gregg Wolper does not own shares in any of the securities mentioned above.