How to Turn a 3% Return Into a 10% Gain

Would you consider a 10.5% annualized gain a satisfactory investment return for the five years ended Aug. 31, 2013?

Would you believe it if you were told you could have gotten that result from one of the worst-performing and most unpopular large-growth funds of that time period:  Fidelity Magellan (FMAGX), which posted an anemic 3% annualized, time-weighted gain and watched investors pull nearly $20 billion out during that span?

Would it further shock you to learn that you could have squeezed that performance from the much maligned Magellan by buying it the same month Lehman Brothers imploded, committing to an automatic investment plan, and then doing next to nothing for the next five years?

Moral Victory
It's true. You could have snatched victory, of sorts, from the jaws of defeat by dollar-cost averaging, or making regular periodic investments, into some of the least-loved funds in the industry over the past five years. It's only a "sort of" victory because you still could have done better than many low-ranked, redemption-besieged funds using the same approach with index funds. It's telling, though, how much difference a little perseverance would have made with funds like Magellan.  

Investors, however, have had little patience for actively managed equity funds since the financial crisis. The 10 funds with the biggest outflows in the past five years through August were almost all active equity funds and seven of them had Morningstar Analyst Ratings of Gold, Silver, or Bronze.

Some of the funds on the most-redeemed list have given investors plenty of excuses to leave. Magellan's and  Davis NY Venture's (NYVTX) five-year rankings, for example, are deep in their respective categories' cellars. It's hard to understate the antipathy some investors harbor for these and some of the other most heavily redeemed funds. It's not unusual for Morningstar analysts to hear from disgruntled former shareholders who claim to have owned the offerings for years until they sold at a loss.

That would've been possible with Magellan. Although it was actually up 3% on a time-weighted basis for the five years ended in August, Magellan's Morningstar Investor Returns, which factor in shareholder purchases and sales to estimate the average investor's experience in the fund, show a 2% loss for that period. The fund has been in steady outflows for much of the past decade, but net redemptions reached a five-year high in 2011, just before Magellan gained nearly 18% the following year under a new manager. So, a lot of investors missed on the fund's recent recovery. We don't know where typical Magellan sellers took their business--they could have found a better fund or buried the money in mason jars in the backyard. The evidence shows, however, that fund investors usually hurt themselves with their trades, subtracting about a percentage point from the returns of the average fund. So, it's possible that at least some Magellan investors made a bad situation worse by selling.

What Ifs
That got me thinking: What would happen if investors instead did what they are supposed to do: buy, hold, and dollar-cost average? If the strategy improved investors' results at Magellan, which still gets a Neutral rating because of its long-term mediocrity under a succession of managers, what would it have done for heavily redeemed funds that Morningstar analysts actually recommend?

I took the 10 medalist funds with the heaviest outflows of the past five years and asked what would happen if an investor made a $10,000 investment in each of them at the start of the period and kept adding $1,000 per month to each no matter what. The funds I chose had more outflows than 99% of all funds in the past five years and Morningstar Investor Returns that were, on average, more than 2 percentage points worse than their time-weighted returns.  

  - source: Morningstar Analysts

The hypothetical dollar-cost averaging scenario described above would have improved the funds' time-weighted results and Morningstar Investor Returns by several percentage points each.

Indeed, investors who followed this strategy in  American Funds Growth Fund of America (AGTHX), which experienced more outflows than any fund during the time period, would have turned a 6.4% time-weighted annualized gain into a 10.7% one. The approach would have had the biggest impact for  Dodge & Cox Stock (DODGX) investors. On a time-weighted basis, it gained a respectable 6.8%; those who stuck with the regular investment plan more than doubled their gain to 14.6%.

Not Best, But Better
It helps that nearly any purchase in the past four years of a rising stock market has been a good one. But the discipline that dollar-cost averaging imposes on investors--forcing them to buy more shares in market valleys and fewer at peaks--would have helped investors in these funds systematically take advantage of equities' dips and rebounds.

Granted, in most cases you could have done better than most of the funds in this tiny, unscientific sample by following the same strategy in funds that passively tracked indexes like the S&P 500 Index ( Vanguard 500 Index's (VFINX) dollar-cost averaging return was second only to Dodge & Cox Stock's in this group). There also have been credible studies demonstrating that, over long periods, investing in lump sums beats regularly putting a little bit at a time to work. Still, this exercise shows that systematic investing can help investors avoid the psychological potholes that often undermine their personal results, such as buying high and selling low. Sticking with a plan can improve the results of even funds suffering bouts of lousy relative performance.