The idea that investors care mostly about chasing hot funds is clearly false.
The longstanding perception of mutual fund investors is that they blindly chase short-term performance, piling into last quarter’s hottest funds and sectors. One problem with this caricature is that it doesn’t jibe with the well-established correlation between fund flows and the Morningstar Rating for funds. These star ratings, unlike the category rankings that they displaced, are not based on short-term raw performance but instead focus on longer time periods and adjust for risk and for cost. If asset flows correlate with star ratings, then investors and their advisors must be thinking longer term and paying more attention to cost and risk than they are given credit for doing.
Morningstar’s new research on money-weighted returns, or what Morningstar calls Investor Returns, reveals a fascinating insight into what drives fund flows and further belies the notion that investors naively chase short-term performance. In looking at the difference in fund flows among major fund firms, we found that there was a 19.6% positive correlation during the 10-year period through August 2011 between total returns and fund flows relative to asset size at the 25 largest fund-management firms. This tells you what you would expect—firms with better performance tend to attract more money. It further suggests that mutual funds are part of a reasonably efficient system for allocating capital. Money flows to the better managers, who in turn allocate capital to better stocks. If the correlation didn’t exist, and dollars simply flowed to the best-marketed funds, then the industry would be dysfunctional.
What’s interesting about this research is the further exploration of the correlation between flows and investor returns. Investor returns estimate collectively how much money a fund actually makes for investors. It weights performance more greatly in periods where more money is in the fund and conversely discounts performance when the fund has less money under management. It doesn’t tell you what any one investor made, but it gives you an idea not only how well the fund performed but whether or not investors managed to deploy the fund successfully.
Stunningly, the correlation between fund flows and investor returns dwarfs that of the correlation with total returns. We found a 49% correlation of flows with investor returns over this 10-year period, two and a half times the magnitude of the correlation with traditional total returns. What this tells us is that investors aren’t chasing hot funds but instead are behaving in a perfectly rational way. They are returning to places that have produced good investing experiences for them and moving away from firms that have tempted them to buy high. What fund investors really want is a fair shake, not last quarter’s performance darling. This notion is further bolstered by the correlation we’ve seen between Morningstar’s Stewardship Grades and fund flows.
The idea that investors care mostly about chasing hot funds is clearly false. Even the correlation with longer-term raw performance is only moderately strong. The correlation that matters is what investors actually experience. This insight has obvious implications for fund companies—they should shed short-term sales goals and instead focus on being better stewards of capital. It also has big implications for financial advisors. While it’s impossible to track asset flows among advisors, it’s axiomatic that, because most flows into funds go through an advisor, the trends seen at the fund level must apply to advisors as well. In other words, advisors who produce better investor returns for their clients are more likely to see their practices grow, even if their raw performance numbers may lag flashier competitors.
What investors care about is meeting their own goals. Most see money as a means to an end, not as a contest to outgain their neighbor. Advisors who focus on maximizing short-term returns play to a small and very fickle subset of the individual-investor community. Those that take a longer-term, client-goal-centric approach appeal to a broader and more loyal demographic. Headlines like “7 Funds to Buy Now” may garner web traffic, but that’s not what resonates with serious investors. Wise advisors have long built their practices along this insight, which flies in the face of the perception of mutual fund investors as performance-chasers.