Mark Brandon is the Managing Partner of First Sustainable (http://www.firstsustainable.com), a registered investment advisory catering to socially responsible investors. In addition to Socially Responsible Investing (SRI), he may opine on social venturing, microfinance, community investing, clean technology commercialization, sustainability public policy, green products, and, on occasion, University of Texas Longhorn sports.

Tuesday, December 06, 2005

Reason #3 to Fire Your Mutual Fund Company

Seventh in a Series

The next several posts are going to be dedicated to the proposition that small investors are getting ripped off with mutual funds thanks to a complex scheme of self-dealing and back scratching.

Reason #3 - Chasing Performance

Just as fund companies tend to overstate the expertise level of their youthful, call-center "investment advisers" (see Reason #5), management also tends to attribute what the evidence shows to be more-or-less luck to extraordinary investment acumen. As I've said before, the exorbitant fees charged for active management would be well worth it, if superior returns were consistently delivered. But, the returns are not being delivered, and the fees are mostly not worth it (especially the overpriced, advisor-pushed funds). What's worse, while I concede that in any given year, two thirds of fund managers will beat the market, that percentage decreases dramatically as the time horizon lengthens. In fact, using a manager's good track record has been shown to be one of the worst things you can do when picking a fund. The maxim of past performance as no guarantee of future results is right.
In fact, superior past performance is almost a guarantee of sub-par results in the future. If you read the advertisements for mutual funds in the business pages, they are likely accompanied by smiling, happy, healthy people and in big numbers, the 1, 5, and 10 year returns on the fund. If they are really gutsy, and have happened to beat the S&P 500, they'll compare those numbers with the index as well. However, this only tells part of the story. First, every well managed fund that delivers consistently faces a huge upsurge in dollars to invest, making it harder to deliver those outperforming returns. Do they make this clear in the advertisement that the superior returns delivered many years ago are harder to come by now that they have 10x or more to manage? No. Second, one of the true benefits of operating a huge fund complex with dozens or hundreds of funds means that, at any given time, one of them will be outperforming. This means that the funds are touting what is hot at the moment, keeping silent about their underperformers, and exacerbating the first problem. I am reminded of the book maker who makes ten picks a week, so that he can be sure to have some correct calls to tout the next week.
The “Hot Hand” theory, as espoused by University of Illinois Finance Professor Josef Lakonishok, tells us that any fund manager who outperforms one year can expect to continue to outperform for a maximum of 10 subsequent quarters. Lakonishok attributes this to market momentum more than any investment acumen. As money pours into that manager’s fund and funds like it, asset prices are bid ever higher. After the period of overperformance, if there is indeed one at all, the manager is more than likely to underperform, and sometimes drastically underperform. The key takeaway is that you should not be enamored with advertisements of hot funds.

On top of this phenomenon, you should be aware that herd mentality makes it difficult for any fund manager. On a macro level, history bears this out. For example, in the early stages of the 1990’s bull market, fund inflows were about one tenth of the level in 1999-2000, when the market was at its peak. Conversely, fund outflows were at their peak in 2002-2003 when the market was at its bottom. The result was a $4 trillion dollar hickey to the small investor in the form of paper wealth vanished. To the extent that the fund industry continued with their deceptive advertising, they deserve some blame.

Tomorrow: Reason #2 – Technology Eclipses Their Reason For Being

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