Buy-High/Sell-Low Cycle
Fund Investors To Blame For Poor Returns, Ray of Hope Shines
Fund investors have a nasty habit of buying high and selling low. We have been noting this phenomenon since 1999 and invented a measure of real fund shareholder returns to capture the gap between how well a typical fund investors does compared to the funds they invest in.
A Wall Street Journal article covering a report issued by Dalbar Inc. once again highlights how poorly fund investors perform compared to the market.
The 2007 report found that while the past 20 years have been a boon to the mutual-fund industry, the average investor has earned only a fraction of the market's results. That's because mutual-fund performance is based on an investment held throughout a specific time period -- one, three, five, 10 years, etc. -- but investors frequently don't hold the funds for the entire period. Instead, they pour in cash as markets rise and start a selling frenzy after a decline. In addition, new funds, funds that surge in popularity and funds that close, may cause investors to switch or withdraw their money, which can lower returns, depending on when they occur."
Shockingly, "The average equity fund investor's 20-year annualized return jumped to 4.3% from 3.9% in 2006". In other words, because of bad timing, fund investors may have done better in a low risk and low fee money market fund.
One possible salvation discussed in the article is asset allocation funds – funds that own a mix of stocks, bonds and cash. These funds tend to be boring for most investors as they never show up on top performance lists. However, less volatile returns means performance chasing fund investors are less likely to make ill-timed buys and sells.
While buying a low fee asset allocation fund and falling asleep at the wheel is generally superior to chasing hot funds and fund categories, the good people of MAXfunds feel a more active fund investor can increase their returns by essentially doing the opposite of the fund investing herd – buying good funds in fund categories others avoid, increasing allocations to stock funds in general when other investors are scared, and cutting back on stock funds when optimism is high.
Green Stocks Too Hot?
Marketwatch reports that so-called "green" stocks, the underlying investments of environmentally-focused socially responsible funds, could be heading into speculative bubble territory.
'It was just a year ago where we would have somebody arguing with us over whether or not the market would ever favor green investing,' says Jack Robinson, co-manager with Matt Patsky of the Winslow Green Growth Fund. "What a difference a year makes.'
Indeed, some green fund managers now see the share prices of many companies tied to environmental sustainability as, well, unsustainable. 'Now you've got to worry about valuation and some of the speculative bubbles that are building,' Robinson says.
'I'm certainly concerned that you have too much hot money moving in,' says Eric Becker, co-manager of the Green Century Balanced Fund , which keeps about two-thirds of its portfolio in stocks and the rest in bonds. 'There are investors who are going to get burned.'"
We feel investor exuberance (and lack thereof) is a key factor in investing decisions. There are many ways to keep tabs on how overblown an investing idea is. Initial public offering volume and excitement is one indicator, as is rising prices and investor enthusiasm.
However, just because a few stocks go public and a few others rise does not mean the party is over. We consider fund investor behavior to be a little more indicative of bubbles and future bad performance than hot stock performance in an area. On each fund data page on MAXfunds.com, you will see our “Hot Money Index” which measures how much money is flooding into a fund. We also measure hot money across all funds in a fund category.
You'll note that many of these green funds do not have much hot money, meaning they are not bringing in the hundreds of millions (and sometimes billions) of new cash we often see before an area stalls or worse, crashes. But before jumping to the conclusion that this means there is much more upside here, be aware that most of this sort of “trendy” money these days goes into ETFs, not old fashioned open end funds.
While the typical fund investor hasn’t put many chips on the alternative energy table in open end funds in the last year, ETFs have had more success. We now have new ETFs like PowerShares WilderHill Progressive Energy (PUW) and PowerShares Wilder Clean Energy Portfolio (PBW). The later is tipping the scales at around a billion dollars, pretty big money for a gimmicky new fund. New fund launches are another negative sign – fund companies tend to launch new funds near the top not near the bottom of any cycle. PBW has brought in more than ten times what the newest open end alternative energy fund has brought in – Guinness Atkinson Alternative Energy (GAAEX) - even though this open end fund has performed better than the ETF.
Bottom line, if you look just at open end funds, we have more to go in this speculative area. When you bring in ETFs, we look a lot closer to the top in alternative energy stocks.
Green funds mentioned in the article:
Winslow Green Growth Fd (WGGFX)
Sierra Club Stock Fund Inv (SCFSX)
Chase Performance, Loose Big
Why did that top performing mutual fund hit the skids right after you bought in? Because you, along with about a gazillion other performance chasing investors, flooded it with more money than it could handle. Mark Hulbert in the New York Times reports on a study by Berekely finance professor Jonathan Berk which argues that the main reason most top performing funds can't continue their winning ways over the long term is that they become overwhelmed with new investor money.
The reason that so few mutual funds beat the market over the long term is that investors shift too much money into the successful ones, or so the theory goes. As a result, these funds’ managers quickly become swamped with more money than they can invest profitably, causing performance to suffer.
A helpful analogy, Professor Berk said in an interview, is to the so-called Peter Principle, which predicts that employees will be promoted until they reach their level of incompetence. Similarly, a mutual fund manager who beats the market will continue to attract more assets until he can no longer beat the market."
Unfortunately, while funds with outstanding recent performance is usually followed by a period of underperformance, lousy past performance is not a predictor of good things to come:
This theory has been less successful, however, when applied to the worst-performing mutual funds. Less-able managers should become competitive once their portfolios become small enough, because, according to Professor Berk, it is easier to beat the market with a smaller portfolio than with a larger one. So, as investors shift money out of a lagging fund, its size should stabilize at whatever lower level is necessary to give its manager a fighting chance of beating the market.
If this part of the theory were right, the worst performers would be no more likely to stay bottom-ranked than top performers to remain top-ranked. But that is not the case, according to the professors. A low-ranking performer, in fact, has a significantly greater chance of continuing to be a low-ranking performer than a top-ranking performer does of staying at the top."
Berk believes that poor performers continue to perform poorly because investors tend to stick with these dogs instead of selling. "By not selling, this loyal group prevents poor performers from becoming small enough that their managers can become competitive again."
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Don't Buy Top Ranked Funds
We've said it before, and we'll say it again: when shopping for mutual funds, resist the urge to purchase top performers.
Given the scads of mutual funds out there, investors might be tempted to turn to the want ads rather than sort through heaps of funds in hopes of finding a good match. More often, befuddled investors depend on fund rankings to bring a cool empirical eye to their search. But those who invest solely based on rankings risk disappointment.
'Using historical top quartiles to predict top quartile performance is a bit like rolling the dice,' said Srikant Dash, an index strategist at Standard & Poor’s Corp. S&P found in a recent study that few funds that ranked among the top quarter or even top half of their peers managed to consistently maintain their performance.
In the past five years, only 13.2 percent of large-cap funds, 9.9 percent of mid-cap funds and 10 percent of small-cap funds were able to remain ranked among the top half of funds for the entire period.
The top 25 percent ranking proved even more daunting a challenge, with only 3 percent of large-cap and 2.5 percent of mid-cap funds staying in that zone for five straight years. Stats for small-cap funds were even more grim: None was able to hold onto a top 25 percent ranking for the entire period.
'The numbers are similar to what would happen if you just pick a fund randomly,'" Dash said.
Buying the funds at the top of this year's performance chart is step one of the all-to-common buy-high/sell-low cycle that is probably responsible for destroying more fund investor wealth than loads, high fees, and manager ineptitude combined (step two is selling that fund after its almost inevitable subsequent poor performance).
Schwab YieldPlus Investors Run After Fund Goes PriceNegative
Ultra short-term bond funds have been collapsing since early July 2007, and the carnage is going from bad to worse. Apparently investors in these funds - billed as slightly higher risk alternatives to money market funds - are liquidating in droves:
Ultra-short bond fund Schwab YieldPlus (SWYPX) is the latest victim of the credit crisis. It has fallen 16.8% for the year to date through March 26, ranking dead last in its category, and as a result, investors have been fleeing the fund. Assets have fallen precipitously from a high of $13.5 billion in June 2007 to just $2.5 billion as of March 20.
The fund's sizeable loss in recent months is certainly shocking, as ultra short-term fixed-income securities are generally perceived to be safe investments with minimal interest-rate and credit risks..."
Schwab YieldPlus has fallen almost 20% since late January 2008 - four times more than the Nasdaq drop during the same period - which is particularly troubling because the upside of the fund was slim - perhaps 1% more than an investor would get in a traditional low-fee money market fund. As Schwab's website notes, "the fund’s objective is to seek high current income with minimal changes in share price. " This is the type of fund an investor might park some cash they need in a few months to pay for college tuition or to buy a house - or just to avoid the risk of the stock market or even longer-term bond funds.
Ultra short-term bond funds' trouble started last year. The adjustable rate mortgage and corporate debt these funds invested in was far riskier than the investment grade ratings would lead one to believe. The current trouble has as much to do with the open-end fund structure itself as with continuing home-loan and other adjustable debt mark downs: when investors panic sell all at once the fund manager has no choice but to sell portfolio holdings at the same time to raise cash - often at lower prices than the fund thought the holdings were worth.
Sudden increased selling by fund shareholders leads to lower security prices of the fund holdings which drives the fund price or NAV down even more, which in turn leads to more fund investors selling. As many of these types of funds have "Free, unlimited checkwriting" and all have no redemption fees, there is nothing standing in the way of nervous shareholders getting out. Selling at large funds like Schwab YieldPlus can drive prices down for other funds that own the same or similar securities as well. Mutual funds in such a death spiral will not come back to their original price even if the hard hit portfolio holdings rebound in price.
See also:
Why You Should Worry About Your Bond Funds
Is Your Bond Fund a Ticking Sub-Prime Time Bomb?