Reuters Money

The best investments often don’t have the highest returns. I know this is heresy to most, yet mass behavior can be a siren song.

About this time every year, we gaze intently at our portfolios, hoping against hope that we did something right. Sometimes we get lucky.

Two years ago, we didn’t even want to open the envelope containing the bad tidings of the market meltdown. I kept my mutual fund statements sealed that year.

This year, there’s some palpably good news to spread around, although it doesn’t necessarily involve the best-performing investments.

Unfortunately, those who noted and invested in the best performers in ETFs recently are doing exactly the wrong thing. They are loading up in overheated funds when the general consensus is that this is the right thing to do. As previous market manias have proven, “the lemming effect” is something that millions of investors routinely forget or ignore.

Case in point are the sizzling returns of the most-popular ETFs this year. The iShares Gold Trust (IAU), with a three-year return of almost 20 percent (year-to-date as of Dec. 13), was one of the darlings of the precious metals crowd. The SPDR Gold Shares (GLD), iShares Silver Trust (SLV) and Powershares DB Precious Metals ETF (DBP) were not far behind.

As economic klaxons sound alerts about the troubled Euro and Dollar, investors have herded into precious metals with abandon. The SPDR Gold Shares fund alone has grown to more than $54 billion in assets.

If you knew the mortgage and stock meltdown that began three years ago was going to be a blood bath, then metals would have been a good investment. Yet most people look backward and think they are clairvoyant. Metals become very unpopular as soon as governments get a grip on their affairs, which seems to be happening in Europe and may just happen to some degree in the U.S.

It doesn’t even matter that the top funds invested in metals. It could be pearls or platinum. Asset classes fall in and out of favor for various reasons and almost no one can predict when to get out. That applies to nearly every mutual fund or ETF. Performance persistence is like a blue diamond in fund returns.

According to a Standard & Poor’s study earlier this year, only 4.3 percent of big-company stock funds that placed in the upper-half of their rankings stayed on top five years later (through Sept. 2009). The hottest funds are destined to cool off. Much of their performance is due to luck, not skill.

That brings me to some dull-but-prudent investments that also topped a Lipper mutual fund list recently. Low-cost Vanguard and iShares, favorites of my retirement portfolio, dominated the ranking of top-25 cheapest funds. These are passive index funds that hold baskets of securities and charge you bargain rates for annual management expenses.

This elite group of ETFs makes absolutely no sense if you only look at three-year returns. My top pick — the Vanguard Total Stock Market Index fund (VTI) — lost almost 6 percent over that period, mostly due to the rotten returns from 2008.

When you look at the Vanguard stock fund’s one-year return, though, it’s a respectable 18.6 percent; the two-year gain is about 15 percent. So why would I recommend a fund that has a negative average return over three years? Should somebody pull my financial journalist’s license?

The Vanguard fund gives you something the metals funds don’t. It’s a bountiful basket of most of the U.S. stock market. It delivers the benefits of real earnings and dividends at a cost of 0.07 percent annually for management expenses, compared to 0.51 percent for its peers.

Notice where the zero lines up to the right of the decimal place. Most actively managed stock funds don’t sample virtually the entire market — they guess every year which stocks will do well and charge you roughly 1 percent or more annually.

More importantly, rather than bunching up a bet on one volatile asset, the Vanguard fund makes thousands of bets simultaneously. I know this is little consolation when you are seeing some metals funds up 40 percent this year, but spreading out your bets lowers your risk and increases your returns over time.

Speaking of risk, why not lower it further by investing in the PIMCO 1-3 year U.S. Treasury Index (TUZ)? Like the Vanguard fund, it’s efficiently managed (0.09 percent in expenses). It may also be a safer place to be when interest rates rise, since the short-maturity Treasury bonds it holds won’t be hit as hard as funds with longer-maturity notes.  Remember that when interest rates rise, bond prices fall (unless you are holding a secure bond to maturity).

I’m sure my picks will be disappointing to most, even in my own profession, who love to tout winners of the past and pretend that’s prudent investment advice. Like Ulysses, though, I’d rather lash myself to the mast of a solid boat than be dashed on the rocky illusions of recent returns.