“Today mutual funds are home to $7 trillion and one of Wall Street’s biggest fibs,” writes Ian McDonald in today’s Wall Street Journal.

“No, I’m not referring to the swirling allegations that some funds quietly struck deals letting large investors execute improper fund trades at the expense of regular folks in recent years. The continuing fund-trading probe grows more startling and shameful each day, but let’s set that hornet’s nest aside a moment.”

“Instead, let’s turn to a more fundamental problem, namely that, despite all the scrutiny of fund returns, the average investor tends to end up owning a gaggle of losers. The main culprit might be the long-cherished theory that too-often decides which funds are picked for magazine covers, marketing campaigns and our portfolios. Put simply, it’s this: Funds that have topped their peers over the past few years draw our attention (and money) because they’re likely to keep doing so. Despite constant caveats that past performance doesn’t guarantee future results, it’s an idea endorsed by the vast majority of investors from Wall Street to Main Street.”

“It’s also bunk.”

“That’s the upshot from a study Chicago investment researcher Morningstar Inc. will publish in its bimonthly “Mutual Funds” publication next week. The study has the pragmatic goal of trying to figure out whether past returns are any use as a divining rod for finding funds and managers that will prove their mettle in coming years.”

“The results are downright depressing. Let’s look them over and then mull a few nonperformance criteria that might actually be better fingerposts.”

“Morningstar’s study looked at rolling one-, three-, and five-year returns for each fund in Morningstar’s nine diversified stock-fund categories and its “foreign stock” category from 1992 through 2001. Each fund was ranked against its category peers over each period.”

“Funds ranking in the top quarter of their peer group over the past 12 months managed to keep their ranking over the following 12 months only one-third of the time. Those that ranked among the top quartile over the past three and five years fared even worse, managing to repeat the feat less than 20% of the time, according to Morningstar’s tally.”

“The dreary findings slap one of the fund industry’s oldest and most misleading ideas.”

” ‘There’s almost a blithe acceptance of the predictive power of past performance out there,’ says Jeffrey Ptak, a Morningstar fund analyst who steered the study. ‘Whether through fund ads, the way managers are touted in the media, or the way investors research funds, past performance is put on a pedestal, and that assertion just didn’t hold up well under scrutiny.’ “

“These findings are particularly alarming since they looked at fund returns stacked against their peers. After all, that’s how most fund screens are designed: to sift funds according to their relative returns against their category peers. That might be a better yardstick than dissimilar funds, but apparently it doesn’t tell you much about what’s to come.”