Don't Believe Everything You Read

Listening to the Bear
Last week, three professors (Gottesman, Morey, Rosenberg) released a study finding that retail mutual fund investors don't favor managers who outperform during downturns. Entitled Is There an Incentive for Active Retail Mutual Funds to Closet Index in Down Markets? Fund Performance and Subsequent Annual Fund Flows between 1997 and 2011, the paper concluded that active fund managers would be wise to copy market indexes during bear markets, because investors don't reward the relative winners. Therefore, write the professors, there's little incentive for managers to deviate from the benchmarks in downturns. They should, as the term goes, "closet index."

My immediate reaction was suspicion. My reaction one week later after reading the paper and conducting some informal analysis: suspicion confirmed.

I don't doubt the professors' math. They examined 15 years' worth of data on diversified U.S. stock funds (the article's title is too broad), comparing one year's relative fund performance with the next year's inflows. They used the usual academic statistical tools of multiple regressions and tests for significance. For the typical diversified U.S. stock mutual fund, the relative performance posted during the four down years covered by the study (2000, 2001, 2002, 2008) had little effect on the next year's inflows.

However, a year-by-year analysis doesn't really get at the issue. Fund investors typically make decisions based on longer-term factors than 12 months' worth of performance. Sure, a huge annual gain can attract attention and speculative buyers, and a huge loss can chase out the previously faithful. For the most part, though, one year's result is merely another data point.

Also, the professors' decision to equal-weight the data carries implications. Per the study's approach, all funds count equally--the minnows as well as the whales. That's fine for some purposes, but not for others. What if, for example, investors favored stock funds that dodged the 2000-02 crash, but gave their money to only a handful of the biggest, best-known, and best-promoted funds? In such a case, the study would find little if any sign that investors care about bear-market performance, since only a few funds were rewarded. However, that might be where most of the money went.

Indeed, that was where most of the money went. Take a look at the top-10 selling funds of 2003, which accounted for half of all U.S. equity fund sales that year:

 

 

Nothing but conservative, technology-light funds that fared well in the 2000-02 bear market, along with two index funds. At the bottom of the heap, those funds that suffered the greatest outflows, were several offerings from Janus and Putnam--two fund companies that had loaded up on technology stocks entering the New Millennium, and which got spanked for their temerity. Had investors paid attention to the bear-market results? You betcha.

The story for 2004 was much the same, as was 2005. In fact, by 2005, the taste for bear-market stars was so great that the 10 top-selling U.S. stock funds accounted for more than 100% of the group's net sales, as they picked up $57 billion in new assets, with the rest of U.S. stock funds at a collective negative $2 billion. Once again, the leaders consisted of eight bear-market winners plus two index funds.

 

  

(If you're wondering about  American Funds Growth Fund of America's (AGTHX) dominance--and yes, it crushed all stock funds for 2004, too--that's because the fund managed the unique feat of catching the bull market in the late 90s, then dodging the hangover. The fund's rank relative to its large-growth peers in the years 2000, 2001, and 2002 was 4, 12, and 15, respectively. It was a true bear-market hero.)

The story was similar in 2009. Few U.S. stock mutual funds of any kind attracted net inflows in 2009. Those that did were index funds, three brand-new funds (there was a sales advantage in not being forced to show 2008 results!), and then several funds that had beaten the S&P 500 the previous year. No active fund that trailed the S&P 500 in 2008 made 2009's top-10 list. Collectively, these 10 funds gained $40 billion in new monies, with all other U.S. stock funds receiving an aggregate $58 billion in redemptions.

Let's kick the argument up a notch. Not only was bear-market performance the driving force for the past decade's list of top-selling U.S. stock funds, but it also was the biggest factor in the active versus passive contest. Most actively managed U.S. stock funds beat the S&P 500 in each of the years 2000, 2001, and 2002, thereby slowing the relative advance of both index mutual funds and exchange-traded funds, so that actively managed stock funds outsold both through the middle of the oughts. When active funds failed to outperform the benchmark in 2008, though, investors turned to passive funds--and have been there ever since.

It's all about the bear. 

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.