The Best (and Worst) Type of Fund Company

Climbing the Ladder I expected this column to examine investor returns for the major fund families--the dollar-weighted performance numbers that consider not only the results of a fund, but also the decisions of its shareholders. Funds that appreciate when they have few owners, and then decline after becoming popular, aren't useful. They might impress on paper, but they fail at the only task that matters: making money for people.

However, investor returns are a noisy signal even at the best of times, and these have not been the best of times. Sure, they have been splendid for investors--but not for an indicator that evaluates how well, or poorly, shareholders navigate bumpy markets. The mutual fund ride has been too easy, for too long. It has been nine years now since investors were tested. (Admittedly, that was a whopper of a test.)

So, I will take a different angle. Rather than run through the current numbers, I will draw upon studies that Morningstar has conducted over the years, as well as anecdotal experience. What approach to fund investing has served investors well? Which approaches have not? We'll begin with the ladder's lowest rung, and work up from there, finishing at the top.

Rung #1: Flipping Funds The worst investment practice is to buy funds with the intent of selling them over the next few years. This no doubt sounds obvious to a U.S. audience in 2017. However, from the global perspective, the flaw of this strategy has been anything but self-evident. Particularly in Asia, many overseas countries have churned and burned their funds. Buy 'em while they are hot, sell them when they are not, and find something new once again.

Even in the United States, the tactic is not unknown. For decades, unit investment trusts have been a small but persistent segment of the fund marketplace. UITs are born to die--they launch, they operate, they expire, they are launched again. The sales commissions and tax bills they generate are high; their returns less so.

Rung #2: Buying at Launch One step higher stands the approach of buying funds when they are initially launched and planning to hold them forever. Examples would be buying closed-end funds during their initial subscription periods, or a new mutual fund that is being marketed. Such funds don't possess termination dates, so that in theory the shareholder can hold them for decades. That certainly improves upon buying funds that are scheduled to perish.

Often, though, the result is the same. Historically, investors mostly bought new funds on hope--the expectation that the fund followed a fresh and different investment strategy, which would lead it to outgain the existing competition. And mostly, they were wrong. Their cutting-edge purchases didn't perform better than their old-school rivals. The general reaction from frustrated owners was to dump the fund (and perhaps the advisor who placed them into it) and buy something else.

Happily, the number of launch-party investors has been declining. The mistakes have been learned, particularly among financial advisors, many of whom were routinely duped during the 1980s and '90s by aggressive fund companies that oversold gimmicky investment concepts. (Imagine looking a client straight in the eye and pitching an infant "short-term multimarket income fund.") Do-it-yourself investors have also changed their habits, although they were less prone to the tendency in the first place.

Rung #3: Tactical Allocation This is significantly better. Tactical allocation enhances the previous strategies by having a plan. Buying funds as they come to market, whether intending to move them later or to hold them, is the investment equivalent of butterfly collecting, by bringing a net and scooping up whatever flies by. The eventual result is accidental; the accumulation occurs by the whim of the breezes, not through the collector's intent.

In contrast, tactical allocation seizes control of the investment process. It is not influenced by what the fund companies are currently offering. It is instead commanded by the investor, and it connects individual needs (such as retirement, college funding, charitable giving) with portfolio structure. The assets now acquire a purpose.

Unfortunately, most tactical-allocation schemes would be improved if they were not tactical. In theory, adjusting portfolio allocations in response to changes in the financial markets makes sense. In practice, that tends to mean reacting to headlines, selling the portfolio's losers, and buying that which is in fashion. Few tactical allocators are truly contrarian. Those who are tend to be successful--but contrarianism is a difficult road to follow, particularly for the financial advisor who must maintain the confidence of the client.

Rung #4: Strategic Allocation Sometimes, less is more. Strategic allocation isn't the simplest of approaches, as it is easier yet to eschew planning and just buy what the fund companies market, but it is less complicated than conducting tactical allocation. The tactical allocator constantly monitors the markets' behavior, staying on the alert for new investment opportunities, or averting danger with one's existing holdings. The strategic allocator, in contrast, is slothful. Buy, file, and forget. (Except for periodic rebalancing.)

The advantage, of course, is that the strategic allocator avoids temptation. It is easy to convince one's self that this time is different, and thus what worked in the past will not succeed in the future. Many investors did just that after 2008, believing: 1) the era of equities had probably passed, and 2) to the extent that it still existed, China would be the globe's new leader. Neither proved true, as U.S. stocks have since been among the world's best investments.

To return this column to its original subject, the fund families that historically have claimed the highest investor returns are those that have advocated strategic allocation: the boring companies that offer broadly diversified core funds. Those firms promoting their ability to adapt to change, through tactical allocation, have fared somewhat worse; and the ones that have constantly rolled out new funds, worst of all.

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.