The Watchlist Fails

One Step Forward, Two Steps Back
Vanguard has issued a new (short) report called Quantifying the impact of chasing fund performance. It delivers a familiar lesson: Don't sell low so as to buy high.

Many have told this story. Morningstar's Russ Kinnel, for example, has long published the "Buy the Unloved" funds series, which examines whether investors are skilled at moving between investment categories (nope). At the fund level, several companies have estimated the size of the gap that separates what funds earn on paper versus what funds earn for investors (who can and do erode paper returns through mistimed trades.)

Vanguard's tale is a bit different. Unlike the aforementioned studies, which measure actual investor behavior, Vanguard's research evaluates hypothetical decisions. Specifically, the report analyzes every possible trade that could have been made among diversified U.S. stock funds during the time period from 2004 to 2013, assuming a rule of selling any fund that trailed its category's average total return over the trailing three calendar years, and funneling the proceeds from that sale into high-performing funds from the same investment category. The results, writes Vanguard, incorporate "more than 40 million return paths."

Yes, that's a lot of data.

For each category, Vanguard shows the median annualized total return for two strategies. The performance-chasers operate as discussed above, initially buying every fund in the category in equal proportions, and then moving cash from losers to winners. The buy-and-hold approach also purchases every fund in equal proportion but makes no further trades.

As evidenced by the chart, buy-and-hold wins in a landslide for the three large-cap categories.

Performance-chasers fare similarly poorly with mid-cap stock categories.

And worst of all with small-company funds.

It's highly unlikely that the performance-chasers compensate for their miserable total returns by being much less volatile. Funds within each category generally have fairly similar risk levels. (Even if they didn't, why would performance-chasing consistently funnel monies to safer funds?) Nevertheless, Vanguard dutifully checked by measuring each group's average Sharpe ratios. Sure enough, performance-chasing was bad in every category for risk-return as well.

Vanguard correctly points out that while most mutual funds sell to retail investors, its study applies to institutional buyers as well. "Research has shown that performance-chasing is not restricted to specific groups or subsegments of investors; rather, both retail and institutional clients have shown an inclination to chase performance."

In that, Vanguard understates the matter. Although the report uses mutual funds as its data source, its truer subject is institutional behavior.

The reason is that retail fund investors generally do not behave as modeled in the study. When they take action, retail owners tend not to swap like funds for like funds; rather, they bail from an asset class that has disappointed and reinvest into an asset that has higher recent returns. In 2008 and 2009, for example, fund owners cleared out of stocks and moved into bonds and (to a lesser extent) alternative investments. Last year with the stock-market indexes surging to record levels, investors rediscovered their appetite for equity funds. With funds, selection and asset-allocation are intertwined.

The growing dominance of indexing has increased that trend. Only rarely will investors trade this large-growth index fund for that large-growth index fund, or this total-market index for that one. With passive investments, generally moves occur because of asset allocation. And, as detailed in last week's column, passive investments now gobble up two thirds of net new fund sales. Thus, the relevance of this Vanguard study is undermined by...Vanguard.

However, this research remains strongly relevant for institutional investors. Although of course institutions also do a great deal of indexing, when they do use active managers, they pride themselves on separating the allocation and selection decisions. Have a high-yield account that is lagging? Fire that manager, hire a better junk-bond manager. Ditto for a market-neutral fund, or a European stock fund, or a merger-arbitrage hedge fund, and so forth.

In evaluating these trades, institutions are served by consultants who rate, sort, and rank each category's managers. Those managers who disappoint are placed on a watchlist, with the threat of being replaced by a better manager. This watch process is a critical element of institutional investing. Retail investors might buy something, file it away, and forget about it, but not institutional investors. They monitor. When need be, they take action.

Are their actions as disastrous as modeled in Vanguard's study? Surely not. No institutional investor follows a trading scheme that is as radical as that in Vanguard's report. The institutional owner will place only truly poor relative performers on the watchlist--funds in the lowest decile, or possibly the worst quintile--as opposed to the entire bottom half. And the institutional owner usually won't immediately jettison such funds. The funds are placed on notice. But often they can and do recover, and remain in the portfolio for many more years.

Nonetheless, Vanguard's study fires a powerful warning shot at watchlists. The lesson: Be very careful indeed about taking action on those lists. Most trades will inflict more damage than they prevent. The report also indirectly offers guidance to the retail fund buyer. Although they are unlikely to be making within-category trades as modeled by this study, they still must consider what indicators are helpful for selecting a fund when putting their money to work. Clearly, a high relative three-year return is not one of those indicators.

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.