A 19th century economic philosophy known as utilitarianism preached the virtue of trying to deliver the greatest amount of happiness to the largest number of people. Even if the idea were still widely followed today, it wouldn't describe what often happens in the mutual fund business.
Many funds have a nasty habit of performing best when relatively few investors are around, then fizzling after the shareholder base balloons.
Take Peter Lynch. He scored most of his biggest gains when Fidelity Magellan counted less than $1 billion in assets, including a few superb years when the fund wasn't even open to the public. As a more recent example, PBHG Growth gained 350% from 1991 through 1995, when assets generally hovered below $1 billion, but since then the fund has lagged the broad market as its girth expanded. Then there's the case of Garrett Van Wagoner, who has yet to duplicate the stellar gains he enjoyed at the Govett Smaller Companies Fund, even though his Van Wagoner Emerging Growth portfolio attracted more than $500 million during its first year of operation, in 1996.
If investors tend not to fare as well as the funds in which they invest, they partly have themselves to blame. Brokers say they constantly receive inquiries from performance-chasing clients or prospects about one hot fund or another. "I get them all the time--every day almost," says Skip Mooney, a Dain Bosworth rep in Colorado Springs, Colo.
Performance chasing is easy to explain in terms of human nature, and brokers succumb also. "People tend to overextrapolate from the past, not just investors but professionals, too," says Mark Stumpp, senior managing director for Prudential Investments in Short Hills, N.J. They tend to assume that a fund's historic performance numbers will continue into the future, without asking themselves whether the past several months or years were atypical, or whether the fund or its management team has changed in the process.
And let's face it: Investors lean heavily on a fund's track record because it's usually the most quantifiable and exciting piece of information about the portfolio. Performance is more meaningful and interesting than, say, a fund's investment objective, standard deviation or beta.
"Unfortunately, people tend to gravitate toward performance because there's not a lot else you can rely on," says Stumpp.
Many fund companies aggravate the problem by touting good past-performance numbers in ads. Brokers, the media, investment newsletters and other commentators compound the problem by focusing on leading funds rather than laggards.
Unfortunately, getting to the root of what caused the superior performance--especially over the short haul--isn't easy. "It takes about 20 years of performance to determine if a manager is skillful or just plain lucky," says Stumpp. "You could be chasing random noise."
Investors also underperform their funds because they don't give them ample time to do their thing. An ongoing study by Boston-based Dalbar suggests that stock fund investors tend to hang onto their funds for only about three years on average--not long enough to benefit from a full cycle or two in the stock market. Compared to the 16% compound annual return posted by the S&P 500 index from January 1984 through December 1996, Dalbar estimates that investors in broker-sold stock funds earned 6.2% a year over that stretch, while investors in the do-it-yourself camp achieved 6% annually on average. Dalbar arrived at those numbers after analyzing cash flows and retention rates for investors in stock, bond and money market funds.
The performance gap between investors in the two categories has narrowed in recent years, which Dalbar attributes to a blurring between the two distribution channels in terms of the availability of advice. But the upshot of the study's results, which also can be seen in bond fund returns, is that shareholders tend not to hang onto their funds long enough, which Dalbar attributes to poor market timing decisions.
Transaction-Cost Troubles Fund companies also shoulder some of the blame for shareholder underperformance by failing to close off certain portfolios at optimal asset levels. Put another way, certain mutual funds become victims of their own success.
The reason high-flying funds tend to cool off as they expand in size can be explained by escalating transaction costs, says John Bogle Jr., son of the Vanguard Group founder and a portfolio manager in his own right.
"There's no reason why a fund's performance should regress to the mean, except that good performance enables managers to raise more money, which increases the fund's transaction costs," says Bogle, who oversees three stock funds for the no-load group in Boston.
Transaction costs for mutual funds involve more than just brokerage commissions and bid-asked spreads. They also include market impact costs--the tendency of big funds to affect prices on individual stocks. And they reflect the opportunity costs of having to ease into positions gradually to minimize market impacting trades.
Bogle reached his conclusion after analyzing 16,000 of his own trades, involving stocks of all sizes and investment styles, over a couple years. Many of the trades were made for private accounts. At the extreme, he estimates transaction costs could eat up 11 percentage points in a fund's annual performance. Small company funds are more susceptible to market impacts than larger cap funds, he says.
Bogle believes the best way to ensure good relative performance is to close off funds to new investors, which he's done on two of the three funds he manages. Why don't more funds close? It cuts into asset growth and fee income, he says.
"Following a Map" Aside from keeping an eye on a fund's asset growth, what else can be done to help clients steer clear of performance chasing?
Bob Kargenian, a Prudential first vice president in Newport Beach, Calif., believes a good approach is simply to learn everything you can about the funds offered by a short list of companies and to stick with them. "Get comfortable with two to four fund families and get to know them inside and out," he suggests.
Jay Penney, a broker and chartered financial analyst at the Acacia Group in Phoenix, favors funds that maintain relatively compact portfolios. The managers of such funds have demonstrated a willingness not to dilute their holdings with second- or third-tier choices as new cash flows into the fund, he says. One of his favorites is Strong Schaefer Value Fund, which limits its holdings to about 50 companies.
But perhaps the key way brokers can offer assistance is by drawing up well-diversified portfolios for clients, then urging them to stick with these plans. "We establish a map, and we follow that map," says Mooney. "It keeps people from wanting to jump into the latest hot fund."
The more often you look at a portfolio, Stumpp adds, "the more likely you will feel the need to take some action. But optimally, you want to look at a portfolio only about once a year."
Mutual fund investors aren't the only ones who tend to chase after good performance.
Chasing performance is also a problem with commodity pools, says Jack Schwager, chief executive officer of WizardTrading in Indianapolis.
Schwager discusses the phenomenon in his book, "Managed Trading: Myths and Truths" ($55, John Wiley, ISBN No. 0-471-02057-5). He examined the performance of hundreds of managers under two scenarios:
In the first scenario, a hypothetical investor buys in after a manager has gained 50% from his or her previous nadir. In the second scenario, the investor commits money after the manager has suffered a 25% drop from his or her prior peak. The upshot of this study?
"You would have done much better if you bought after the manager suffered through the bad period," says Schwager. His interpretation: The performance of futures trading managers tends to fluctuate around a mean return.
Size of the pools isn't the problem. "Most managers generally don't grow so much that it becomes a factor," he explains, especially if a trader is dealing in currency, debt or other highly liquid markets. "The basic assumption is that the market goes through phases where different methodologies do well."
Schwager's advice to brokers who want a commodities exposure for clients: Select a manager with an impressive long-term record, then wait for a subpar streak. And couple that by diversifying among different types of managers.
