New Funds Generate More Excitement Than Results

This article was published in the September 2014 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

When a fund posts great returns its first year, we wistfully look back and wish we’d bought in. Who wouldn’t want to have owned  Fairholme (FAIRX) in 2000,  DoubleLine Total Return Bond (DBLTX) in 2010, or  Vanguard Primecap (VPMCX) in 1985?

New funds benefit from small asset bases and a lack of legacy positions. Some enthusiasts of new funds have even argued that these new funds can trade ahead of a firm’s big funds, but I think that’s pretty rare in the current compliance-stringent environment.

A FundInvestor subscriber recently wrote to make a similar case and request that I study the idea. I don’t often take requests, but I figured this was worthwhile even though I suspected the data wouldn’t be encouraging. To test the idea that new funds are more successful than older funds, we gathered data on funds launched in 2004, 2006, and 2008. We grouped them by asset class and looked at how they fared overall. Then we looked forward over the next three and five years to see what returns, Morningstar Ratings, and success rates they generated. The success rate tells us what percentage of funds in a group survived and outperformed over the ensuing period.

Not So Much
So, how’d they do? Not all that well. The class of 2004 produced a five-year success rate of 39% compared with 41% for the fund universe at large. The funds that did survive had modest 2.8 and 2.9 average star ratings over the ensuing three- and five-year periods. So, this tells me new funds overall don’t have a big advantage, though they also don’t suffer a big disadvantage. Results are just modestly worse than for the fund world as a whole. Balanced funds produced a respectable 51% success rate, but the other groups were lousy.

For the class of 2006, the results were a bit worse. The five-year success rate for that class was 36%--a fair amount below the 41% for the fund universe. The star ratings for three and five years were 2.7 and 2.8 on average. This time, foreign-equity funds had a decent 47% success rate and taxable-bond funds produced a 53% success rate.

However, if you look at the results from the three years of new funds you’ll see there’s no particular pattern to asset-class figures that would lead you to say that one is actually a good bet when it comes to new funds. For example, taxable-bond funds had a 39% success rate in the 2004 class but a 22% success rate in the 2008 class.

The class of 2008 had the worst success rate of all at 35%, most likely because it’s tough to launch a fund at the start of a bear market. In this case, just 333 of the 481 funds launched in 2008 were around at the end of 2013. Thus, a huge number of mistakes were swept under the rug. The average star ratings of survivors were a bit higher at 2.9 for both the three-and five-year periods. I think that’s mainly due to how many funds were killed off. Naturally, a fund that starts life with a huge loss faces long odds of ever turning a profit for the fund company, so many more underperformers were killed off from the class of 2008 than others. In sum, odds are against new funds. It can seem like the opposite is true because we don’t take notice of most of the lousy new funds that start poorly and get killed off quietly. Thus, our selective memory makes them seem better than they are.

  - source: Morningstar Analysts

Why Don't They Have an Edge?
New funds tend to be mediocre because fund companies make them that way. Some will try the shotgun approach in which they blast out a bunch of funds, figuring that they’ll come out ahead of the game even if only 20% hit it big and gather enough assets to be profitable. Fund companies that take this approach are interested in quantity, not quality. Today, you see this behavior most in the exchange-traded fund and alternative funds world, where there is a land rush going on, but it still happens in more traditional open-end funds.

Another reason is that fund companies tend to slap high expense ratios on new funds. The thinking is that shareholders in that fund should bear the costs of the fund’s small asset base. But of course that makes the odds of success even longer. I don’t really like the practice. I think all fundholders should be given a fair deal. If it’s worth launching, then the fund company can eat some costs for a while. Typically, they eat only a small amount of the costs but leave the actual price paid by investors well above average. You wouldn’t open a restaurant that charges double if the restaurant is only half full. Not everyone does this, though. Vanguard, Dodge & Cox, Fidelity, and American Funds generally offer funds that are fair deals from the start. 

Finally, new funds are more likely to have less-experienced managers. Fund managers have to learn somewhere, and it’s often at new funds.

Should You Avoid New Funds?
New funds perform a little worse over their first three and five years than the general fund world, but I wouldn’t avoid all of them. You just have to know the limitations and tune out all the marketing dross around a new fund. Instead, look for seasoned managers and decent expenses. 

There may not be many keepers among new funds, but if you pay close attention, you’ll see some that are. If a manager of a fund with a Morningstar Analyst Rating of Gold or Silver launches a new fund, then by all means dig deeper. If the fund has low costs, you have much better chances of success. And if a new fund employs a strategy where small assets are an advantage, then that vaunted flexibility may actually be an advantage. Funds that trade less-liquid securities like small caps or high-yield bonds come to mind.

  - source: Morningstar Analysts

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