- Top Performance Lists Are
Dangerous.
Probably the single most
potentially dangerous action a mutual fund investor can take is
to glance at these ubiquitous lists. Funds make the top of the
lists not because they are like all the rest of the funds, but
because they are decidedly different in some important way. Risk
is usually the first important difference. For stock funds,
holding stocks that are more volatile than the average stock,
holding fewer stocks, or concentrating on only a few industries,
raises risk and puts a fund in position to have a greater chance
at making the top of the list.
As an example, take sector
funds. You can't beat the market by holding it, which is why you
can always find a sector fund of one kind or another at the top
of most performance lists. Call it stock picking, or industry
weighting, or both, but the net effect is increased risk, and
less diversification than the overall stock market.
Picking the funds at the top
of the performance lists assumes that either these same stocks
or sectors will continue to do well, or that the managers can
continue to deftly take high risk and move money around better
than all the rest.
For domestic bond funds,
making the top of the list is a result of the maturity structure
of the fund's portfolio. The longest maturity bond funds will be
at the top of the performance lists when interest rates are
falling, and at the bottom of the lists when interest rates
rise. So, investing in bond funds that are at the top of the
list is a forecast of interest rates—that they will stay
constant or continue in the same direction, a prediction that
even professional interest rate prognosticators have been
woefully unsuccessful in getting right.
However, these top/bottom
lists may hold a small glimmer of value. There is some empirical
evidence that stock funds at the top of the heap one period have
a greater likelihood to have this superior performance in the
next period, on average—"hot hands" may stay hot. Why might a
fund's superior performance persist? Probably because the
stocks/sectors emphasized in the portfolio continue to have
positive momentum into the next period. The shorter the time
periods observed, the more likely this is to be true:
quarter-to-quarter performance persistance is more likely than
year-to-year. But be careful, this is based on performances of
top funds, on average, and investors don't invest in fund
averages, but instead invest in individual funds.
What is more telling, however,
is that bad funds tend to continue to be bad. But again, be
careful. If an entire category of funds—small stock value funds
or emerging market funds, for example—do poorly, then making the
bottom list is probably meaningless if your fund has a lot of
peer companions. But if large stock growth funds populate the
top list or simply are not to be found in numbers on the bottom
list, and your large stock growth fund makes an appearance at
the bottom of the pile, it isn't a good sign.
And, of course, being a
knee-jerk contrarian and buying funds that make the bottom list
on the theory that what falls must rise, is probably a seriously
flawed approach to fund selection.
- Size Matters.
The amount of money invested
in a fund does matter, but whether larger is better than smaller
depends on the investment objective of the fund. With a large
stock index fund, a U.S. government bond fund or a money market
fund, the more dollars under management the better. This is
because they all operate in very liquid segments of the market
where large block transactions are less likely to impact
prices—pushing prices up when purchasing and down when
selling—and large-scale transactions might prove to be cheaper
to accomplish. In addition, large amounts to manage in these
funds will not interfere with their investment objective. And,
since some fund expenses are fixed, spreading these expenses
over more investment dollars should reduce expenses as a
percentage of fund assets.
On the other hand, funds with
investment objectives that cover less liquid market
segments—small stocks or emerging markets—can be too large. That
means that individual trades will tend to be larger, which may
in turn lead to higher transaction costs tied to security
pricing, a wide bid-asked spread on the stocks, and make
portfolio changes harder to accomplish. The classic response of
funds that focus on small stocks is to migrate investments to
mid-sized and large stocks when they start to achieve a large
asset base.
Actively managed stock funds,
when managers are picking stocks and industries and moving money
around, can be flooded with new money and find themselves unable
to deploy new money expeditiously or effectively. And a flood of
new money usually comes after a performance that garners
widespread attention and is often difficult to replicate,
particularly with the surge of new investment in the fund. An
index fund, passively managed and operating in a liquid segment
of the market, would not be stumped by a large, sudden inflow of
cash.
How large is large? When it
comes to net assets, $100 billion may be just fine for an S&P
500 index fund, but $1 billion may choke an actively managed
small stock fund. And beware of funds that had extraordinary
performance when they had $100 million or less, a relatively
small amount in net assets. In order to invest larger amounts
they may have to invest money in more stocks and industries,
increasing diversification and decreasing risk, dulling
performance.
- Fund Expenses Can Be Costly.
Fund expenses count. And they
count more for some investment categories than others. The
general rule is that if you invest in a fund that has a
significantly higher expense ratio than the average for its
category, the long-term performance drag will be costly. Few
active fund managers cover the cost of the increased expenses of
active management compared to the rock-bottom cost of passively
managing an index fund. And if a fund manager is saddled with a
relatively high expense ratio due to a small net asset base or
high management/research costs, or both, the task of providing
above-average category performance is all the more difficult.
Some managers, when faced with this dilemma, may boost the risk
level of the fund to remain competitive.
Stock funds are more expensive
to manage than bond funds, international funds are more
expensive than domestic funds, and funds with large asset bases
are cheaper than small funds. But if the expense ratio of a bond
fund is approaching 1.00%, or a stock fund 1.50%, think twice
before investing. And don't forget stock index funds often
change 0.25% or less.
- Loads Are Loads.
Whether the sales charge, or
load, is up front when you buy into the fund, at the end when
you sell the fund, or is an as-you-go 12b-1 charge included in
the expense ratio, it will cost you. Loads go to sales
organizations and sales personnel; they are not used to secure
better portfolio managers, better research or better anything. A
load reduces your return dollar for dollar. So if you are not
getting financial advice worth the load, buying a loaded fund
will cost you, perhaps dearly. Load funds do not outperform on
average similar objective funds with no loads, and in fact they
tend to underperform by the amount of the load. How could they,
given what loads are used for? Want to invest with a hot manager
in a fund that is loaded? Given the iffiness of historical
performance as a predictor of future performance, find a no-load
fund with a similar style, performance and risk, and save the
load charge.
Don't forget that almost all
fund performance data is reported without adjusting for
front-end or back-end loads. However, performance data does
adjust for the 12b-1 charge because it is included in the
expense ratio, and fund performance net of the expense ratio is
accounted for in performance statistics.
- Market Timing Doesn't Work.
Wouldn't it be wonderful if
either you or your fund manager could time the market? You'd
make a mint, but it's only a dream. Nobody, but nobody, has
consistently guessed the direction of the bond or stock market
over any meaningful length of time, although many will make the
claim. And remember that to be successful, timing requires two
calls: When to get out, and when to get back in.
One reason beyond low expense
ratios that index funds are tough to beat is that they are
always 100% invested in the market—they have no cash
holdings—when the market takes off. Index funds always call bull
markets correctly and they never miss a rally. Yet, they always
fail to call a bear market or correction. However, being right
on every bull market, as well as avoiding transaction costs and
minimizing taxable distributions, is tough to beat.
Since returns on stock and
bond funds have been distinctly positive on average annually
since we have started keeping records, being ready for bull
markets is more important than avoiding bear markets.
When investing in actively
managed stock funds, you should hope for superior stock and
industry selection, not market timing. If your actively managed
portfolio is building up a large cash balance, in excess of 10%
of the portfolio, your manager is either engaging in some subtle
market timing or there has been a recent rush of cash into the
fund. Either case may ultimately lead to poorer performance. For
bond funds, when maturities are significantly shortened or
lengthened, the impetus is usually market timing driven by an
interest rate forecast.
- Give New Managers and Funds
Time to Prove Themselves Before Investing With Them.
With the thousands of funds
and fund managers in the investing universe that have track
records of at least three years, why invest in an untried fund
or manager? While finding funds that will be top performers in
their category before the fact is daunting, avoiding disastrous
fund investments is within reach. But it requires something upon
which to base a judgment. At least a three-year performance
history that can be compared to the performance of funds with
similar investment objectives and assumed risk is indispensable
to evaluate a fund manager or a fund. Consistently favorable
performance relative to a peer group of funds over different
market environments provides no guarantees of future
performance, but it is infinitely better than nothing. You would
be surprised how many new funds are quietly buried and new fund
managers transferred after the first few disappointing years.
