Don't just sit there, do something! For investors experiencing below average mutual fund returns this advice seems reasonable. Too often the action plan involves selling assets from one fund and buying assets in a fund with a better performance record.
Research has shown that not only do retail investors chase performance but so do institutional investors. Although both own mutual funds, individual investors own 95 percent of them.
Chasing performance succeeds only if past performance can predict future performance. Performance chasing could provide a benefit if there is repeated and prolonged outperformance from year to year. Investors who chase performance assume that performance persistence is rather strong. Buy and hold investors, on the other hand, assume that performance persistence is weak and that excess performance is not likely to be achieved by chasing performance.
A year-old study by Vanguard using Morningstar's database of about 3,500 funds, excluding funds in existence for fewer than three years, has some interesting findings.
The clear winner was buy and hold. Returns in all nine of the Morningstar equity style boxes show the returns produced by the buy and hold strategy beat those of the performance chasing strategy.
Top performing mutual funds during a three-year period have experienced weak performance in subsequent time periods.
Although the impact of
transaction cost and taxes were not included in the study we can conclude that if they were included the results of performance chasing would be even weaker.
Buying mutual funds based on qualitative and quantitative factors and then maintaining a disciplined long-term time horizon is a simpler and much more effective way to increase returns. Chasing returns is not.
Here are some suggestions to choosing mutual funds. First, is the mutual fund manager really active? You do not want a "closet indexer," a fund manager who charges a higher fee than an index fund but is essentially running one anyway. Does the fund manager have any "skin" in the game? Morningstar found that fund managers who did not invest in their own funds had the lowest success rate versus its peers. Those managers that had more than a million invested had the highest. Keep costs low. Time and time again it has been shown that low management fees lead to higher returns. It is one of the most important factors in selecting any investment.
Investors are naturally drawn to top performing actively managed mutual funds. This ends up being a performance chasing circle of failure. Selling low and then buying high over and over again.
This approach is wrong. The buy and hold approach has outperformed performance chasing over the last decade. Investors should understand that some periods of underperformance are inevitable. Investors should remain disciplined and avoid the temptation to chase performance.
That often ignored legal disclaimer: "Past performance is not necessarily indicative of future results" seems to hold true among recent top performing funds. Investors are well advised to remind themselves of it often.
Michael T. Doll, an investment adviser with the Longboat Key Financial Group, can be reached at 941-383-2300, ext. 6, or Michaeltdoll@longboatkeyfinancial.com.