Why the “top performing” funds may not be the best investment
A 2007 mutual fund study unveiled a telling paradox for individual investors: the average investor underperformed the average mutual fund by between 1.82% and 2.28% on an annual basis. While it seems inexplicable that everyday investors were unable to even match the average mutual fund performance, the explanation, in fact, is really quite simple. The majority of investors continually gravitate towards the sectors and funds with the top short-term results. Unfortunately, these sectors and funds rarely remain as the top performers, and often become among the weakest, leaving their investors with below average returns. In order to understand this seemingly irrational behavior of buying high and selling low it is important to understand why investors incessantly chase short term performance and why mutual funds are unable to maintain their above average returns. The good news is that there are some relatively easy steps that investors can take to counteract some of these factors leading to low returns, but first an explanation of the causes is necessary.
In order to facilitate an explanation of the dynamics confronting individual investors when choosing a mutual fund, it is first important to examine the ways in which the mutual fund industry operates. Mutual fund companies make money by increasing the amount of assets that they manage by either adding new investors to existing funds or by creating new funds. In both cases the mutual fund company will have to market the funds either directly to investors or through the intermediaries, such as financial advisors, that individuals go to for investment advice. All of this marketing costs money and like any business the mutual fund company will spend their money in a way that will produce the best results. As advertisers know, humans are pre-programmed to search for patterns and extrapolate those patterns into the future. Naturally, mutual fund marketing departments will focus on the funds that are doing the best, knowing that in an almost pavlovian fashion investors will gravitate towards those funds by naively assuming that the returns will simply continue into the future. High returns also gain the attention of the press and the top funds and their managers are profiled along with numerous convincing reasons that their current success will continue unabated into the future. It is only a matter of time before cocktail party conversations are filled with stories of these savvy investments and all the money that has been made from these top performing funds. Human nature takes over and investors develop a herding mentality as the past returns, the favorable press coverage, and the desire to keep up with peers and not miss a “sure thing” act as a powerful inducement for pulling the trigger on the latest hot investment.
While it is clear how these factors can lead to investors chasing the funds with the top returns, the key question is what effect does this have on the fund manager and future returns. The efficient market hypothesis states that securities are always priced exactly as they should be, and that each future price movement is random as it is the result of future events that are by definition unknowable. For proponents of this theory, the reason that top performing funds will underperform in the future is merely reversion to the mean. Simply stated, the theory dictates that funds that outperform do so because of luck and eventually that luck will run out. Even for those who disagree with the efficient market hypothesis and believe that managers can consistently outperform the market, one of the inescapable ironies of the mutual fund business is that the larger a fund grows the more difficult it is for the mutual fund manager to continue to earn market beating returns. An overall market or sector is really just the average of all the securities in it. As a mutual fund grows in size it more closely resembles the market as the manager is forced to purchase more and more securities. Most funds have a mandate that the majority of the cash in the mutual fund must be invested quickly as investors do not want to pay mutual fund fees to hold cash. As greater amounts of investor cash comes into the fund the manager is forced to come up with more and more above average “ideas” as the pressure grows to continue to find securities that will outperform the market. Understanding the difficulty of investing large sums of money, mutual fund companies will often close funds to new investors at certain asset levels to stop the manager from being inundated with new cash to invest. However, just because a fund is still open to new investors does not mean that it is not too large as the motive to generate higher profits is a powerful enticement for the fund to remain open after it has exceeded its optimal size.
While there is no fool proof system to avoid the potential pitfalls of top performing funds, there are some steps that individuals can take in order avoid the fate of the average investor. Although it is clear that past performance is not necessarily indicative of future results, the historical record that a mutual fund manager generates is really the only basis you have for making investment decisions. When trying to find a new mutual fund look for managers that have a long term record and see how their fund performed over different market cycles. Finding a manager that has outperformed over long periods of time but has run into trouble lately can be one technique to avoid the bias of over emphasizing short term results. Avoid mutual funds that limit their investments to a small sector of the market as even if the manager continues to outperform other funds the sector can collapse (see oil stocks and commodity funds in the second half of 2008). Buying index funds can be a good way to avoid funds that are poised for underperformance but be sure that you are not simply selecting an index with recent outsized returns but diversifying across all asset classes. Finally, avoid constantly switching the mutual funds that you are invested in as constant changes can trigger increased fees that further lower your returns. Maintaining a consistent asset allocation by rebalancing your portfolio on an annual basis will lesson the chances that you will continually try and chase the top performers. The simple act of rebalancing will force you to sell your best performing sectors or funds and invest the cash in the sectors or funds with lower recent returns. At the very least, maintain some skepticism when presented with the next “can’t miss” investment and realize that sticking with a set plan will ultimately produce better results.