Making Money Where Others Fail

This article originally appeared in the June 2007 edition of Morningstar FundInvestor.

We've all seen them--the folks who repeatedly switch freeway lanes into the one that was traveling fastest.

They do the same thing with their mutual funds. Morningstar Investor Returns--dollar-weighted estimates of how the typical investor in a particular fund has fared over time--show that investors have robbed themselves of potential returns by jumping in and out of funds at inopportune times.

A fund's volatility is a key contributor to poor investor returns. Investors often chase great-performing funds, only to have trouble staying the course when the same fund hits a rough patch. The result can be substantial gaps between a fund's stated total returns and its investor returns. We decided to look at what other factors lead to poor investor returns.

We used statistical methods to control for a handful of variables that we thought might explain poor investor returns. We started with performance-related factors, such as market returns, volatility, and a fund's investment style, as measured by Morningstar category.

Then we added such operational factors as fund family affiliation, sales-load structure, share-class type, and redemption fees that we thought would likely influence an investor's ability to stick with a fund over time. We looked at a decade's worth of unweighted and asset-weighted data and found some interesting patterns.

Sales Channels Don't Matter
It turns out that investors who paid for the advice of a full service broker and bought load funds ended up with no advantage over those who bought no-load funds either on their own or through a financial planner. In addition, investors in retirement plans did a bit worse than the rest of the world, even though they can patiently invest each paycheck and presumably have a long-term time horizon. Our guess is that while they have a long time horizon, 401(k) investors also have the freedom to change their investments with a couple of mouse clicks and the temptation proved too great.  

We even tested to see if investors in institutional share classes did better than the masses and were surprised to find they did not. Aren't they supposed to be the smart money?

It's Categories That Matter
Although there wasn't much of a pattern in fund share classes, there was a strong pattern by category. We found that the Morningstar categories with the biggest gaps between their 10-year total returns and investor returns were among the most volatile in our database. Most of these categories also share an easily identifiable style profile that has grabbed the press' attention during periods of outperformance.

We all remember endless articles trumpeting the skyrocketing returns of technology and communications investments in 1998 and 1999. The trouble is that the hype often hits a fever pitch deep in the rally and just before its peak, with ugly results for most investors.

Weighing In
To better approximate the experience of the largest number of investors, we asset-weighted our data. Several large funds with solid investor returns boosted the asset-weighted returns for entire categories. For example, the investor returns for the health category benefited greatly from asset-weighting.  Vanguard Health Care (VGHCX) and  Fidelity Select Health Care (FSPHX) have accounted for nearly half the category's assets, and they have strong investor returns.

Asset-weighting had an even greater impact in the world-stock category. There, four funds-- American Funds Capital World Growth and Income (CWGIX),  Vanguard Global Equity (VHGEX),  Templeton Growth (TEPLX), and  American Funds New Perspective (ANWPX)--cranked out solid investor returns while accounting for more than 65% of the category's assets. Such sizable differences show that although there is a group of performance-chasers bent on misusing funds, investing with discipline in the right funds can deliver solid investor returns in even the toughest categories.

Family Ties
We didn't find fund-family affiliation to be a great predictor of investor returns. For sure, there are shops, such as Vanguard and American Funds, that have consistently delivered solid investor returns, even in some of the toughest categories. But most often, apparent links with a fund family were better explained by Morningstar category type. For example, many of the shops with strong investor returns, such as Dodge & Cox, have compact fund lineups that cover only core investment types. This is one of the main reasons that we like such shops. They don't launch flavor-of-the month funds to capitalize on market momentum and current investor sentiment.

Meanwhile, Fidelity has funds in nearly every category, but steady performance from larger funds means that its investor returns nearly equaled those of Vanguard and American.

Temptation Provided
The mutual fund industry has provided plenty of temptation for investors inclined to chase  performance. We used survivorship-bias-free data to take a year-by-year look at the number of funds offered in each Morningstar category. The results were telling.

In periods of robust performance by a category, the category's new fund launches jumped at a rate greatly in excess of the overall industry's average. For example, in the early 1990s there were only 20 share classes in the technology category. By 1999's peak in technology stocks, there were more than 200 technology share classes. The launch frenzy actually overshot the crash in technology stocks by more than a year, presumably because funds already in planning still launched.

The number of technology funds has receded since the market for technology stocks crashed and funds started closing. A similar pattern is present in nearly all categories with poor investor returns. In fact,we found a fairly solid correlation between categories with big trailing two-year returns and an uptick in new fund issuance. That's why it's reasonable to foresee a bad experience awaiting some investors in real estate funds. (Editor's Note: This was written in June 2007.) The number of real estate share classes has nearly tripled in recent years.

Impatience Kills
A look at short time periods shows how destructive impatience can be. For example, investors chased performance into the communications category throughout 1998 and 1999, arriving just in time for its peak. But then they made things worse by getting out near the bottom in 2002. As a result, they missed the group's big rebound in 2003, with disastrous results. On an asset-weighted basis, the typical communications fund returned 48% in 2003, while the average investor return was negative 36%. Arriving late for the party, getting stuck with clean-up duty, and leaving before the next party starts is an all-too common trend in many categories.

How to Use Volatile Funds
Although a few extreme funds with huge standard deviations approaching 20 are nearly impossible to use, sector funds and emerging-markets funds can be used if you go in with a good plan. First, keep such funds to single-digit positions in your portfolio so they can't destroy your core. In addition, go in with the plan of holding on for 10 years or more so that a bad year won't sink you.

Next, don't buy when returns and headlines are huge--go in when returns are small so that you aren't buying a frothy market. Finally, don't lose your head and throw out all the important fundamental investing criteria that you apply to core holdings. Costs, management, and strategy still matter.

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