“Investors who want to kick the tires of a mutual fund often take a good look at its top 10 stock holdings,” writes Tom Lauricella in today’s Wall Street Journal.

“These, after all, are the fund’s biggest investment bets, which managers frequently describe as their “best ideas.” When the managers go on television to offer their stock picks, there is a good chance they will talk about issues on their top 10 lists.”

“There is another reason investors turn to the top 10 holdings: They don’t have a choice. Funds are required to disclose their full portfolios twice a year, but some companies such as Fidelity Investments disclose their biggest holdings two additional times a year. Janus Capital Corp. discloses its funds’ largest positions six times a year and Vanguard Group posts top holdings on its Web site monthly.”

“But how valuable a tool is the top 10 list as an indicator for the fund as a whole? Analysts at Chicago fund-tracking firm Morningstar Inc. wondered if the top 10 really were a manager’s ‘best ideas,’ shouldn’t those stocks trounce the investment performance of the overall portfolio?”

“It turns out investors ought to take a manager’s top 10 holdings with a grain of salt. In only 48% of the funds screened did the percentage returns of top 10 holdings beat the performance of the overall portfolio, according to the new Morningstar report. Far from being way above the performance of the overall portfolios, the average annual return on the top 10 was 13.2%, slightly less than the 13.4% average for the funds as a whole.”

“The lesson, the study’s authors say, is that while the biggest holdings can help in understanding a manager’s style or the type of stocks a fund will own, there is nothing magical about the performance of the stocks residing at the top of the list. ‘On average, the fifth pick is no better than the 30th pick,’ says Russel Kinnel, director of fund analysis at Morningstar.”

“Interestingly, the results also show that a manager whose top 10 performance lagged behind that of the portfolio as a whole isn’t necessarily a bad stock picker. Numerous funds follow the pattern of Needham Growth Fund, to name one. It was one of the best-performing midcap ‘growth’-stock portfolios over the past five years, but results of its top 10 holdings trailed the entire portfolio by 20 percentage points a year during that period, Morningstar found.”

“The Morningstar study compared the performance of the top 10 holdings for 1,157 U.S. stock funds over the past five years with the returns of the entire portfolios. The returns on the 10 biggest holdings were calculated for each period until the next top 10 stocks were disclosed by the fund, after which the process was repeated. (This methodology, of course, doesn’t capture buying and selling in the top 10 holdings between the portfolio disclosure dates.) The returns on the top 10 were then compared with the fund’s overall returns before fees were deducted.”